Legislation Reintroduced to Tax Carried Interests as Ordinary Income

April 7, 2009

Congressman Sander Levin (D-Mich.) recently reintroduced legislation in the House that would tax income and gains associated with "carried interests" as ordinary income.  Similar legislation has been introduced several times in the past, including legislation that has been passed by the House, although not by the Senate.  The new legislation, H.R. 1935, carries over a number of concepts from the prior proposals and builds in new features.  While it is not clear whether the Obama Administration supports this particular bill, the 2010 Budget proposal released by the Administration last month specifically endorsed subjecting carried interests to tax as ordinary income.  

While the prospects for the Levin bill are uncertain, we believe there is a good chance that legislation changing the taxation of carried interest will pass this Congress.  The Joint Committee on Taxation has estimated that the Administration’s carried interest proposal would generate $10.5 billion of additional revenues over five years and $23.2 billion over ten.  The Levin bill has not been scored, so its revenue effects are not yet known.  Nevertheless, the lure of such substantial revenues may prove irresistible as Congress attempts to fund Administration health care, tax, energy, and other priorities.

Ordinary Income Characterization

Under current tax law, a holder of a partnership interest is taxed on its allocable share of the partnership’s taxable income.  Moreover, the character of that income to the partner generally is the same as it is to the partnership.  The proposed legislation would create a special rule that would tax the net income allocated to a partner in respect of an "investment services partnership interest" as ordinary income, regardless of the character of that income to the partnership.  Thus, for example, where the partner is allocated capital gain in respect of an investment services partnership interest, the partner will be subject to ordinary income tax on that amount. 

Similarly, the bill would tax any gain on the disposition of an investment services partnership interest as ordinary income, and, expanding beyond prior proposals, would require the holder to recognize such gain without regard to any other income tax provision.  Consequently, a holder would be subject to tax even with respect to transactions that are generally tax free, such as certain contributions to corporations, transfers to family limited partnerships, and possibly gifts.

While this bill recharacterizes such income and gain as ordinary income, it does not recharacterize it as ordinary income from the performance of services, as formulated in previous versions of the legislation.  Rather, it modifies the self-employment tax regime to require individuals to include any amounts allocated to them in respect of an investment services partnership interest as net earnings from self employment.  On its face, this revised approach suggests that even though these items would be taxed as ordinary income, they would not necessarily be treated as income from the conduct of a trade or business for the purposes of the rules dealing with unrelated business taxable income (UBTI) or as income that is effectively connected with the conduct of a United States trade or business (ECI).

Losses that are allocated in respect of investment services partnership interests, or realized on their disposition, generally also are treated as ordinary losses.  However, such losses are subject to a variety of limitations that essentially limit the losses to the amount previously included in income as ordinary income in respect of the investment services partnership interest.

Investment Services Partnership Interest

An investment services partnership interest is broadly defined as any partnership interest (or interest in any other entity treated as a partnership for tax purposes) held by a person (or a related party) reasonably expected to provide a substantial quantity of investment advisory or management services with respect to certain specified assets.  Specified assets for these purposes generally consist of securities, real estate held for rental or investment, partnership interests, commodities, and options and derivatives with respect to such assets.  Accordingly, the definition would not include interests in most operating businesses.

Qualified Capital Interests

Against this backdrop, there are carve-outs from the general ordinary income rules for investment service partnership interests that are “qualified capital interests.”  Where allocations made to a partner in respect of a qualified capital interest are made in the same manner as allocations to qualified capital interests of unrelated partners that do not perform services for the partnership, the special ordinary income and loss rules described above do not apply.  Similar rules would also exempt dispositions of certain qualified capital interests from the required recognition and ordinary income treatment described above.

A qualified capital interest generally is defined as the portion of a partner’s interest in the capital of a partnership attributable to cash or property contributed to the partnership in exchange for the interest.  It also would include capital interests attributable to amounts included in the partner’s income under § 83.  However, it would not include any portion of the interest acquired with proceeds of a loan (directly or indirectly) from the partnership or any partner thereof.

Disqualified Interests

The proposed legislation also includes provisions that apply similar rules to certain interests other than partnership interests that are received in connection with the performance of management services.  For example, stock, options, contingent or convertible debt, and derivative instruments in an entity other than a partnership or a “taxable corporation” would be subject to similar rules.  For these purposes, a “taxable corporation” only includes domestic C corporations and certain foreign corporations subject to a comprehensive foreign income tax.  This rule appears to be designed to prevent the use of corporations organized in tax haven jurisdictions as “PFICs” to avoid the application of the new rules.

Publicly Traded Entities

Subject to limited grandfathering rules, income from investment services partnership interests generally would not be qualifying income for publicly traded partnerships (“PTPs”).  This rule would not apply to certain partnerships substantially all of whose assets are interests in PTPs or certain partnerships whose interests are convertible into interests in publicly traded real estate investment trusts (i.e., UP-REIT structures).

In addition, payments made pursuant to certain tax sharing arrangements would be subject to tax as ordinary income.  This provision appears to have been designed to limit the benefit of certain arrangements implemented in connection with recent public offerings of investment managers.

Profits Interests

The bill also would codify the basic “profits interest” rule that a person who receives a partnership interest in connection with the performance of services only is required to include the liquidation value of that interest at that time.  In addition, the rule would treat the recipient as having made a § 83(b) election unless the recipient specifically elects out of such treatment.  It appears that this rule providing for the default § 83(b) election would apply even if the partnership interest is not subject to vesting, although it is not clear why.

Regulatory Authority

Included in the legislation is also a provision explicitly directing Treasury to prescribe regulations that are necessary or appropriate for carrying out the purposes of the new provisions.  Specifically, the bill contemplates regulations to prevent the avoidance of the purposes of the new rules, to coordinate with other tax provisions, and to provide other modifications consistent with the purposes of the new rules.

Effective Date

Currently, the bill does not contain an effective date for any provision other than the profits interest rules.  In prior versions of the legislation, the effective date typically was the date the legislation was introduced.  The 2010 Budget, however, suggested that the Administration did not want the carried interest provision to apply before 2011.  Given these differing approaches, it is difficult to predict when these provisions would be effective if the proposed legislation ultimately is enacted.

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Gibson Dunn is closely monitoring this legislation and other developments related to the treatment of carried interests, and we will be providing updates as appropriate.  In the interim, we continue to study these issues and opportunities to limit any adverse impacts resulting from a change in the tax law.

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To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.

Gibson, Dunn & Crutcher LLP

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