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US 'carried interest' law inevitable: what does it mean for hedge funds and other private investment funds?

Thursday, November 04, 2010
Opalesque Industry Update - This article was authored by Stephen Ng, CPA, Senior Tax Manager, Margolin, Winer & Evens LLP.

Hedge funds, private equity funds and real estate partnerships have much to ponder as Congress grapples with finalizing rules of the "carried interest" revenue generator. The bill, which passed in the House on May 28, 2010 as part of the "American Jobs and Closing Tax Loopholes Act of 2010", is currently in the Senate being modified with amendments to the House version of the bill. The Senate proposal would apparently mitigate some of the effect of the bill, with an emphasis towards Venture Capitalists. Upon agreement within both houses, the new law would tax 50% of the "carried" portion of a partnership interest at ordinary rates and the remaining 50% at capital gains rates through tax year 2012, increasing to 75% and 25%, respectively thereafter, if enacted.

This new law will put a damper on those fund managers investment earnings strategy, where for years, their earnings ("carry") was taxed at capital gains rates when passed through to them as a part of their partnership interest. This, in addition to the expiring tax cuts under the Bush Administration, adds insult to injury for some successful fund managers. Unless amended, the maximum ordinary tax rate is set to revert to 39.6%, up from 35%, and the long term capital gains rate to 20% from 15% for tax years beginning after 12/31/10. Fund managers are currently seeking advice from tax advisers on what to do while the outcome is pending. Tax advisers are considering structures that will mitigate the effect of this new law.

Historically, managers were compensated on the appreciation of a hedge fund, private equity or real estate partnership by receiving a "promote" or "carried" partnership interest. Fund managers directed the investments of limited partner’s capital via limited partnership. Upon appreciation of the investments, the fund manager would benefit from his/her share of the appreciation ("carry") through a “profits interest” in the partnership. This occurs through an allocation of partnership earnings to the fund manager (typically the general partner). This was sanctioned by the IRS via Revenue Procedure 93-27, and subsequently clarified in Rev. Proc. 2001-43.

Attorneys and CPAs structuring these funds have relied on this guidance for many years. Under the Procedure, "the IRS will not treat the receipt of such an interest as a taxable event for the partner or the partnership".

However, the items of taxable income, deduction, gain or loss passed through to the fund manager derived by the partnership are taxable in the year the profits interested is granted and thereafter.

In essence, fund managers compensation from the limited partners was comprised of a share in each of the items of partnership income passed through on a schedule k-1 by virtue of the fund manager being partner. Hedge funds, private equity funds, venture capital funds, and even real estate partnerships passed through long term capital gains on the sales of partnership investments that eventually appreciated based on the manager's performance. In addition, when the fund manager liquidated its entire partnership interest, the resulting gain/(loss) would be primarily capital under IRC §741.

As a revenue offset to pay for the Obama Administration's tax breaks, the proposed “carried interest” legislation has gained full steam in both houses. Originally proposed in the House by Rep Sander Levin prior to President Obama's term of office, the legislation became part of the Obama 2010 budget indicating probable passage upon agreement between the houses.

Rep Levin sees the legislation as merely putting investment fund managers on equal footing with other business executive's compensation that is taxed at ordinary income rates. In the Congressman's press release dated April 3, 2009, Rep. Levin posts a 'Myths vs. Facts' dictum referencing corporate CEOs, real estate brokers, book authors and waiters that "pay ordinary income tax rates on their compensation. Only private equity and other fund managers get to pay capital gains rates on their compensation."

The proposed carried interest legislation will treat net taxable income from an 'investment services partnership interest' ("ISPI") as ordinary income regardless of the type of income being passed through (i.e. capital gain, dividend, interest, etc). This "ordinary" recharacterization would also be subject to self-employment tax, as earned income/(loss) by the partner. Net taxable loss for the year would be allowed as ordinary loss only to the extent of previously taxed net income of an ISPI for all prior partnership years.

Any unused net loss is carried forward indefinitely. In addition, complete disposition of an ISPI would also be treated as ordinary income/(loss). An ISPI is defined as "any interest in a partnership which is held (directly or indirectly) by any person if it was reasonably expected (at the time that such person acquired such interest) that such person (or any person related to such person) would provide (directly or indirectly) a substantial quantity of any of the following services with respect to assets held (directly or indirectly) by the partnership: (A) advising as to the advisability of investing in, purchasing, or selling any specified assets. (B) managing, acquiring, or disposing of any specified asset. (C) arranging financing with respect to acquiring specified assets, or (D) any activity in support of any service described in (A) through (C)."

The language is written broadly enough to encompass all types of investment partnerships. 'Specified assets' include securities, real estate held for rental or investment, interests in partnerships, commodities, or options or derivative contracts with respect to any of the foregoing. Currently, the only exemptions under specified assets are farms. An ISPI would not include a "qualified capital interest". A qualified capital interest is a partner's interest resulting from (1) money or property contributed; (2) any amounts included under section 83 (property received for services); and (3) net taxable income taken into account on such interest.

It's important to keep track of any qualified capital interest, as this amount will not be taxed at ordinary rates as an ISPI even if combined with an ISPI. So long as the qualified capital interest can be identified as to the net income and value, bifurcation of the 2 types of interest is required with respect to a fund manager's partnership interest. A qualified capital interest will be respected provided allocations of income, deductions, gain or loss are made in the same manner as to other qualified capital interests of partners that do not provide investment services to partnership. The proposal includes a term "disqualified interest" that would tax any income or gain as ordinary that is essentially any type of derivative in relation to any entity that a person performs services for.

The House passed bill provides for an “applicable percentage” of 50% for taxable years before January 1, 2013, and 75% for years after. The applicable percentage is the amount of any ISPI that is earned in any partnership taxable year. The proposed applicable percentages appear to be a middle ground between the Democrat and Republican parties. Thus, the entire income related to the ISPI would not be taxed at ordinary income rates.

The Senate version of the bill includes an exception for ISPIs and disqualified interests held for at least 5 years, which has not passed, and is currently still in debate. The exception provides any net income or net loss, or sale or exchange of any asset which has been held for at least 5 years, the 50% application would apply indefinitely, including the disposition of such ISPI and disqualified interest.

For example, assume Fund Manager, FM, derives $100,000 ISPI for tax year 2011. 50% of the net taxable income associated with the $100,000 ISPI will be taxed at the ordinary income rates. The other 50% will be taxed at the rates applicable to the items of income, gain, deduction, loss passed through to the ISPI. Any amount of income, gain, loss deduction related to FM's qualified capital interest is not affected by the $100,000 ISPI provided allocations are made in the same manner to other qualified capital interests in the partnership. Assume FM's entire partnership capital account totals $275,000 in the year of the $100,000 carry, which includes $175,000 of qualified capital interest. Upon sale or complete liquidation of FM's partnership interest, only 18.18% (50,000/275000=18.18%) of the gain/(loss) on disposition will be taxed at ordinary income rates. The other 81.82% will be taxed at capital gain rates (long term if the interest was held greater than 1 year) provided the partnership has no inventory or unrealized receivables.

This proposal has tax advisers in an anxious state. Tax rate changes add to the burden of taxing income at higher rates for fund managers. Partnership structure changes related to the earnings for these fund managers will undoubtedly come to fruition shortly. Where available, fund managers are currently considering cashing out their existing ISPI prior to the bill becoming effective as an option, thereby accelerating a long term capital gain on any built up unrealized gains on an ISPIs share of partnership investments. Effecting a liquidation in 2010 affords the currently set to expire 15% maximum rate to apply rather than the 20% rate beginning in 2011.

A recent article in Bloomberg (Edward Lampert, June 8, 2010) illustrated a partnership distributing marketable securities to the fund manager, thereby liquidating the ISPI without selling the actual investments. Under this scenario, the fund manager avoids transaction costs and still maintains the appreciated position with a carryover basis in the investment and tacked on holding period from the partnership itself.

The carried interest proposal would apply to taxable years ending after December 31, 2010. This date is the same in both the House approved bill and the proposed Senate amendment.

Margolin, Winer & Evens LLP is widely recognized as one of the most respected business advisory firms in the Northeast and is consistently ranked among the top accounting firms nationwide. MWE has developed a portfolio of distinct practice groups in response to its clients’ changing needs and growth objectives and is committed to help clients meet the challenges of today’s technology-driven, global business environment. MWE has offices in Manhattan and Garden City. For more information, visit www.mwellp.com


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