Washington keeps coming up with proposals to tax as ordinary income the capital gains derived by fund managers from a carried interest. That idea resurfaced last September in the Obama administration’s proposed American Jobs Act of 2011, and has been put forward again in a bill introduced on February 14, 2012 by Rep. Sander Levin.¹ These most recent legislative proposals, like their predecessors, apply broadly to all funds and joint ventures organized as flow-through entities (partnerships or limited liability companies) in which there are service partners who receive a carried interest (also called a “promote”).²

This GT Alert³ discusses some important changes made in these two bills to the previously introduced anti-carried interest legislation and some actions that fund and joint venture managers should consider taking now to protect themselves against the serious retroactive impact that the proposed legislation would have if it becomes law.

Likelihood of Enacting Carried Interest Proposals

Since 2007, attacks on the capital gain treatment of carried interest incentives have been introduced in Congress repeatedly.⁴ Such legislation has passed the House three times under Democratic control, but failed in the Senate in cloture votes. So why do these proposals keep coming back? Importantly, carried interest recharacterization is a revenue raiser. Proponents of the legislation want to ratchet up the federal income tax burden on fund managers, who are perceived as being hugely remunerated for their services (as opposed to their investment) while being taxed on that remuneration at capital gains rates.⁵ The Obama administration’s 2012 budget assigned a revenue estimate of $15 billion over a 10-year period to its carried interest proposal.⁶

The prospects for any anti-carried interest legislation are doubtful in an election year. But the intensive news coverage recently attracted by this subject underscores the likelihood that the proposal will continue to be pushed by its proponents until it is ultimately enacted in some form. Any carried interest legislation ultimately enacted probably would be made applicable to future income from carried interest deals already in place. This potential retroactive impact makes it important for fund and joint venture managers and their investors to understand the changes made in the Jobs Bill to the prior carried interest proposals so they can provide for flexibility to restructure the documentation and financing for their current deals.

Carried Interests for Service Providers

The term carried interest refers to the percentage of a partnership’s future profits allocable to a partnership’s service providers that exceeds the service providers’ percentage of the aggregate capital contributions. A carried interest is a common way to incentivize a partnership’s managers. It does an effective job of aligning the managers' economic upside with the investors’ long-term interests in hedge funds, venture capital funds, private equity funds, real estate funds and other partnerships. The carried interest rewards the successful manager with an agreed portion of the exit profits, which are generally taxed to the manager at a 15% Federal capital gains rate.⁷ The maximum Federal tax rate on ordinary income, by contrast, is currently 35%.

Same Overall Framework Preserved

Although the carried interest proposals introduced in Congress since 2007 vary in their drafting and scope, they have key features in common with the corresponding provisions of the Jobs Bill and the 2012 Levin bill:

• They substantially increase the tax rate paid by managers and other partnership service providers on their carried interest share of a partnership’s exit profits, because some percentage, or all, of the exit profits derived from ownership of a carried interest would be taxed as ordinary income, rather than capital gain. The proposals likewise increase the tax burden incurred by a manager on gains from selling a carried interest in an investment partnership, or from taking certain partnership distributions in-kind.
• The carried interest gains that are recharacterized as ordinary income are made subject to self-employment (Medicare) tax, the rate for which is scheduled under existing law to increase from 2.9% to 3.8% in 2013.
• Gains from a “qualified capital interest” (i.e., that portion of a partnership interest acquired by the service partner in exchange for capital contributions) continue to be taxed at capital gain rates, and excluded from self-employment tax, provided that such capital contributions are properly structured.
• An interest received in a domestic corporation for services generally would not be covered by the proposed carried interest provisions.⁸

Changes Reflected in Jobs Bill and 2012 Levin Bill

The important changes made by the two current bills to the prior version of the proposed carried interest legislation include the following:⁹

Minimum threshold of passive investment added. As in prior proposals, ordinary income recharacterization would arise for holders of carried interests that constitute “investment services partnership interests” (ISPIs).¹⁰

The two current bills have narrowed the scope of the previously proposed carried interest rules by providing that only an “investment partnership” may constitute an ISPI. The Jobs Bill defines an “investment partnership” as a partnership in which more than half of the contributed capital is attributable to partnership interests that “constitute property held for the production of income.”¹¹ The 2012 Levin bill uses a slightly different wording but reflects the same intent. The drafters of both bills presumably meant that, in order for a partnership to constitute an “investment partnership” covered by the provision, over 50% of the capital contributions would need to be attributable to the interests of passive investors¹² — a substantial narrowing of the scope of the carried interest rules. As a result, ISPI treatment is not imposed if the partners of a partnership all consist of service providers (and the partnership does not own an ISPI), or if the manager group can post 50% of the required capital of a partnership.

Blended rate dropped. Under both bills, ordinary income recharacterization would apply to 100% of carried interest income (prior proposals permitted up to 50% of the carried interest to continue to receive favorable capital gain treatment).¹³ This provision likely will have to return to the blended rate of prior proposals as a compromise in order to be passed by both the House and the Senate.

Dividends received deduction disallowed. Dividends paid to a corporate shareholder from a carried interest would be taxed at ordinary income rates, rather than at the 15% rate applicable to “qualified dividends”.¹⁴

Refinancing inter-partner loans to create “qualified capital interests.” As under the prior carried interest proposals, the Jobs Bill and the 2012 Levin bill allow capital gain treatment to remain in place for the investment profits attributable to a service partner’s “qualified capital interest.” In general, a qualified capital interest is the portion of a service provider’s partnership interest that is attributable to cash or property contributions by that partner.¹⁵ Under the carried interest provisions of both bills, a service provider’s capital gain allocation from an ISPI is not recharacterized as ordinary income to the extent that it is attributed to a qualified capital interest.¹⁶ On the disposition of an ISPI in which any portion of a service provider’s partnership interest constitutes a qualified capital interest, the gain is divided between ordinary income and capital gain under an apportionment rule.

A partner providing services will not be treated as having a qualified capital interest to the extent that the service provider makes such capital contributions with the proceeds of a loan made or guaranteed (directly or indirectly) by the partnership, another partner or a related party.¹⁷ This is true even if the loan is a recourse loan to the service partner. A service partner’s capital contributions are tested only once — at the time they are first made by the service partner to the partnership. As a result, capital contributions made with disqualified borrowings cannot be rehabilitated by a later refinancing borrowed from an unrelated party, or even by repayment in cash by the service partner. The sole exception is that capital contributions made with disqualified loans can be treated as a qualified capital interest if those loans are repaid by a specified date, which is January 1, 2013 under the Jobs Bill (the repayment may not be refinanced with other disqualified financing).

In contrast, the 2012 Levin bill--like the 2010 Senate Bill--would require that the disqualified financing be repaid prior to the date of enactment of the carried interest legislation, meaning that if a service partner waits to refinance in order to see if the legislation is actually enacted, the service partner already may be too late to refinance.

Because of the retroactive impact of the current and prior proposals, service partners should consider refinancing their capital contributions as qualified capital interests now, without waiting to see if this version of the carried interest proposal passes.

Exclusion of Enterprise Value from Ordinary Income Treatment

The 2012 Levin bill, unlike its predecessors, contemplates that upon the sale of a manager’s interest in an investment management firm that holds interests in sub-partnerships, the appreciation attributable to intangible assets will continue to qualify for capital gain treatment.¹⁸ The bill expresses that intent, apparently, in its grant of specific authority to prescribe IRS regulations regarding the “the acceptable methods for valuing investment services partnership interests” held by a management partnership.¹⁹

Effective Date

The carried interest provision in the Jobs Bill would generally apply to tax years ending after 2012 (or after the date of enactment, under the 2012 Levin bill). This gives it retroactive impact because it applies to income from a service partner interest granted when there was no carried interest legislation in effect.²⁰

Impact on Real Estate Funds and JVs

If the carried interest legislation is enacted, it will be a major concern for fund managers and all other service providers having a carried interest, including each local operating partner who has an equity investor as a joint venture partner contributing more than 50% of the required capital contributions. Any carried interest legislation is likely to put pressure on the availability of joint venture equity investment opportunities for pension, endowment and other institutional and family office investors. That is because the carried interest legislation would encourage partnership managers to self-finance their equity and to borrow all investor funds.²¹

But is it feasible to replace equity capital with loans from unrelated lenders? A partnership’s general partner generally would be able to arrange an investor’s entire investment as debt financing only if the investor were able to receive equity-like returns on the loan. The investor would be able to achieve those returns only through the use of profit participation features. The parties would need to be careful, however, in limiting the lender’s upside participation rights, so that the loan could not be recharacterized by the IRS as equity for tax purposes. A reasonable maximum limit (or “cap”) on the participating lender’s internal rate of return would help avoid recharacterization as equity. Equity features should be avoided, such as control rights over the borrower’s management, or an unreasonably high debt-to-equity ratio.

Conclusion

The carried interest proposals have been through many iterations and have undergone a high degree of scrutiny by tax professionals. As a result, the proposals have become very complicated, and there are very few ways to structure out of their application. Service partners should consider refinancing loans from other partners or their partnerships with third party financing to create qualified capital interests, be sure that their tax distribution provisions cover any increased tax rate resulting from carried interest rules, and be sure that all partnership agreements that are being drafted before enactment contain sufficient flexibility to minimize the adverse impact of the carried interest rules if they are enacted.

¹See Jobs Bill, Sections 411 and 412.
²For simplicity, we refer to both LLCs and partnerships as “partnerships.”
³A prior version of this Alert appeared in the Winter 2012 issue of the PREA Quarterly, published by the Pension Real Estate Association.
⁴A tax increase on carried interest gain was proposed by Rep. Sander Levin (D-Mich.) in 2007 and again later that year by Rep. Charles Rangel (D-NY). The House included similar anti-carried interest provisions in the Alternative Minimum Tax Relief Act of 2008, but these were omitted from the version of the law that was finally enacted. Levin proposed a revision of his carried interest legislation in 2009. The House again passed anti-carried interest provisions in the Tax Extenders Act of 2009, H.R. 4213, and passed the provisions a third time in 2010 in an amended version of H.R. 4213. Senate Finance Chairman Max Baucus (D-MT) introduced changes to H.R. 4213 in the Senate on June 8, 2010. Further amendments put forward on June 16, 2010, and June 23, 2010, failed to pass cloture votes in the Senate.
⁵The persistence of the attack on carried interest brings to mind the history of the “economic substance” codification added by Code section 7701(o). That legislation was finally enacted in 2010 after numerous failed attempts, despite widespread criticism by the tax bar, a lack of Treasury support and repeated defeats in Congress. A principal motivation for enactment of Code section 7701(o), along with the related penalties for positions lacking economic substance, was the estimated revenue increase that the Joint Committee on Taxation assigned to such provisions: $4.5 billion over a ten-year period. The proponents of the 2012 Levin bill, however, maintain that the legislation is driven as much by their view of tax equity as by revenue needs. Thus, their bill is entitled the “Carried Interest Fairness Bill of 2102”, and its drafters maintain that it “is not just about raising revenue.” See document accompanying Feb. 14, 2012 Press Release of Ways and Means Committee Democrats.
⁶Treasury Department release of February 14, 2011. The Administration’s estimate was later increased to $18 billion.
⁷The ongoing rental income of a real estate venture, on the other hand, is taxed at ordinary income rates; but in a partnership investing in securities, gains derived prior to the exit may be taxed at capital gain rates, provided that certain requirements are met.
⁸However, an interest in a domestic corporation could subjected to carried interest treatment under the pending bills in any situations identified as abusive in future regulations. See proposed Code section 710(e)(2)(A)(ii)(II). Jobs Bill, Section 412, 2012 Levin bill. Section 3. Amounts recharacterized as ordinary income under any such future anti-abuse regulations would be subjected to the 40% accuracy related penalty under section 6662, unless the taxpayer’s return makes adequate disclosure, there is substantial authority for treating the interest as outside section 710(e), and the taxpayer has a reasonable belief that its position is more likely than not to prevail.
⁹For a complete description of the previous carried interest proposals, see James B. Sowell and Carol Kulish Harvey, “Carried Interest Legislation: Out of Sight, But Not Out of Mind,” Volume 63, University of Southern California School of Law 63rd Institute on Federal Taxation -- Major Tax Planning (2011).
¹⁰Under the Jobs Bill and the 2012 Levin Bill, an ISPI is defined as an interest in an “investment partnership” that is acquired in connection with certain specified management activities of the holder of the interest or a related person. The list of specified management activities is a broad catalog of the services typically provided by managers of hedge funds, other securities funds, and real estate funds. In general, the targeted services involve advice about buying, managing or selling certain assets, or arranging financing for those assets, which include (among other items) securities, real estate and partnership interests. Activities carried out in support of the foregoing are also targeted. See Jobs Bill, Section 412, and 2012 Levin bill, Section 3, proposed Code section 710(c)(2). Proposed Code section 710(c)(4) (see id.) targets management activities provided with respect to a fund’s “securities…, real estate held for rental or investment, interests in partnerships, commodities..., cash or cash equivalents, or options or derivative contracts with respect to any of the foregoing.”
¹¹In contrast, a partnership consisting entirely of service providers would be excluded from unfavorable ISPI treatment under the Jobs Bill except for income allocated to it from another ISPI.
¹²The Jobs Bill also raises the bar with respect to the quantity of services needed in order for the IRS to treat a partnership interest as an ISPI. Prior carried interest proposals were predicated merely on a “reasonable expectation” that a partner would provide “a substantial quantity” of the specified services. The Jobs Bill replaces this with the more exacting requirement that specified services must be “part of a trade or business.” The trade or business must “primarily involve” the specified services, and the wording used suggests that these services must actually have been performed at the time of the determination.
¹³Under the 2010 Senate Bill, the “applicable percentage” of carried interest income that would have been recharacterized as ordinary income was 50% for partnership interests held for more than five years provided the underlying property also was held by the partnership for more than five years. Otherwise, the “applicable percentage recharacterized as ordinary income was 75 percent.
¹⁴Code section 1(h). Prior versions of the carried interest provisions left the dividends-received deduction under Code sections 243 and 245 undisturbed. However, the Jobs Bill disallows that deduction to corporate holders of a carried interest.
¹⁵Property contributions are valued at fair market value for this purpose, unless the contribution is made without gain recognition. A qualified capital interest is increased by amounts included in the service provider’s income under section 83(b) and profits left in the business by the service partner (i.e., the service partner’s income items not offset by distributions or losses). See Jobs Bill, Section 412, proposed Code section 710(d)(7).
¹⁶Additional prerequisites for this treatment are that allocations to the qualified capital interest must made in the “same manner” as to unrelated non-service providers, and the allocations to non-service providers must be comparatively “significant”). For purposes of this determination, self-charged management fees and carried interest are excluded; and IRS regulations may exclude certain lower returns allocated to service providers.
¹⁷Related party status is determined for this purpose under the rules of Code sections 707(b) and 267(b).
¹⁸See document accompanying Feb. 14, 2012 Press Release of Ways and Means Committee Democrats (..”the Carried Interest Fairness Act has been reviewed and revised from previous versions to provide that where there is a clearly separable and verifiable element of goodwill, such as where there is a separate management entity, the manager will receive capital gains treatment for that portion of the gain on sale”..
¹⁹See 2012 Levin bill, Section 3(b)(4), proposed Code section 751(g)
²⁰See Jobs Bill, Section 412(g), and 2012 Levin bill, Section 3(g).
²¹If an investor has any equity contributions and also is a lender to a partnership, all of the loan proceeds are treated as equity contributions for purposes of testing the extent to which the service partners have qualified capital interests. If the investors were to participate solely as lenders, the carried interest rules would not apply.