On Monday, February 2, President Obama formally released his 2016 budget proposal and, as expected, it contained numerous changes to the Internal Revenue Code. Two of the President’s proposals have the potential to drastically alter the existing scheme of partnership taxation. The first concerns carried interests and the second involves master limited partnerships (MLPs).

The President’s Carried Interest Proposal

The President’s budget contains many proposals to close so-called “loopholes” in the tax code. One of these “loophole” closure proposals concerns the manner by which many private equity firms and hedge funds convert ordinary services income into long-term capital gain income. Current law permits partners to receive future interests (i.e., a carried interest or a profits interest) in exchange for services. Since these future interests can generally be taxed at the long-term capital gain rates (assuming certain requirements are met), a partner who receives this type of interest in return for services can avoid the higher ordinary rates as well as the self-employment tax that would generally apply to service income. 

The President’s proposal seeks to end this practice by imposing ordinary rates on the income that partners receive from these types of future interests that are granted in exchange for services to an investment partnership. Thus, the income private equity firms and hedge funds earn from these types of interests would no longer be taxed at the preferential capital gain rates; instead, the income would be subject to the higher, ordinary income rates (and potentially subject to the self-employment tax).

The President’s proposal would not impose ordinary rates on income attributable to qualified “invested capital” a partner has in the partnership. Invested capital is generally money and it is qualified if (1) the investment partnership makes allocations to the invested capital in the same manner as it makes allocations to other capital interests held by partners who do not provide services and (2) the allocations made to partners who do not provide services are significant. Instead, the President’s proposal would tax any gain on this invested capital as capital gain. The President does not intend for this proposal to apply to a real estate investment trust owning a carried interest in a real estate partnership.

It is worth noting that the President’s proposal includes an anti-abuse rule, and the President has noted that additional anti-abuse rules may need to be adopted as creative tax planners study the proposal further and develop workarounds.

The President’s carried interest proposal would be effective for tax years ending after December 31, 2015 and is estimated to increase Treasury revenues by $17.698 billion over the next ten years. This same proposal has been made by the President in several prior budgets and it has not advanced in the Congress.

The President’s Master Limited Partnership Proposal

An MLP is a special form of limited partnership that is publicly traded on a national securities exchange and is exempt from corporate income tax so long as it derives at least 90 percent of its gross income from repeatable natural resources, real estate, or commodities. MLPs have historically been used by investors in the oil and gas industry for higher after-tax returns. President Obama’s budget proposal would cause MLPs to become subject to corporate income tax like other publicly traded partnerships. This will reduce the incentive to use MLPs.

The President’s proposal would be effective for tax years ending after December 31, 2020 and is estimated to increase Treasury revenues by $1.699 billion in the five years after taking effect. Although the likelihood of Congress enacting this proposal cannot be determined, it is worth noting that Congress recently sought to expand MLPs to include renewable energy companies. As such, Congress may not be as receptive to this tax reform proposal as others contained in the President’s budget.