Legislation has been introduced in the House of Representatives, H.R. 2834, which, if enacted, would generally treat incentive allocations (often referred to as “carried interests”) by investment partnerships as ordinary income for the performance of services, which would be subject to ordinary income rates and, in the case of many individuals, self-employment taxes. In addition, any gain realized with respect to a disposition of such an interest in an investment partnership would also be treated as income from services, taxable as ordinary income and subject to the self-employment taxes. The proposed legislative language does not specify an effective date for these rules.

Overview of the Bill

The legislation proposes to add a new Section 710 to the Internal Revenue Code, which addresses income or gain attributable to an “investment services partnership interest,” defined as an interest in a partnership which is held by a person which provides (directly or indirectly) to the partnership, in the active conduct of a trade or business, a substantial quantity of any of the following:

(i) advising the partnership as to the value of any specified asset;

(ii) advising the partnership as to the advisability of investing in, purchasing, or selling any specified asset;

(iii) managing, acquiring, or disposing of any specified asset;

(iv) arranging financing with respect to acquiring specified assets; or

(v) any activity in support of any of the foregoing services. 

A “specified asset” generally includes most types of securities, commodities, derivatives, and real estate interests typically held by an investment partnership. Although many partnership interests are not included under this definition, the legislation may be implemented by adopting a “look-through” approach with respect to investments in “specified assets” made through partnerships.

Under this definition, a person’s “investment services partnership interest” may include its incentive allocation, or “carried interest” in a partnership, but does not include its proportionate share of partnership income or gain with respect to its capital invested in the partnership. The legislative language needs to be clarified to ensure that such proportionate share of partnership gain eligible for capital gain treatment need not be reduced by the incentive allocation to which other partners are subject.

Losses allocated by the partnership with respect to an “investment services partnership interest” are deductible as ordinary losses, but only to the extent of prior income from the partnership treated as ordinary income under the new provision. Although the provision subjects the ordinary income inclusions to selfemployment taxes, it does not appear to allow a corresponding deduction for the ordinary losses for selfemployment tax purposes.

When a partnership distributes appreciated property with respect to an “investment services partnership interest,” the partnership will be treated as if it had sold the property at its fair market value, resulting in the recognition of gain. There is no requirement, however, that this gain be specially allocated to the holder of the “investment services partnership interest.”

Certain Implications of the Legislation

1. Key Definitions Unclear. The legislation is intended to apply to a person who is “actively conducting a trade or business,” and provides a “substantial quantity” of the enumerated services to the partnership. The intended scope of these terms is not yet clear.

2. No Effect on Unrealized Gains and Losses. The legislation deals with the character of income allocated by the partnership with respect to the “investment services partnership interest.” It does not require that unrealized gains and losses of the partnership be recognized by the holder of the interest.

3. Scope of the Legislation. The legislation treats amounts allocated by the partnership with respect to the “investment services partnership interest” as ordinary income for services, but does not otherwise treat the partnership as having paid a fee. Accordingly, the incentive allocation should not be subject to the deferred compensation rules of Section 409A of the Internal Revenue Code, which do not currently apply to partnership allocations. Moreover, as under current law, individual investors in an investment partnership should not be subject to the limitations on investment deductions with respect to the incentive allocations.

4. Certain Collateral Effects of the Bill. Any allocated ordinary income for services pursuant to the legislation will not constitute “qualifying income” for purposes of the exemption from corporate tax allowed certain entities under the publicly traded partnership rules, or income which allows certain regulated investment companies to qualify under subchapter M of the Internal Revenue Code. Such income may also be treated as “effectively connected income” which is subject to U.S. income tax (and possibly branch profits tax) in the hands of a non- U.S. person, and as “unrelated business taxable income” for a tax-exempt organization.

5. Effect on State and Local Taxation. The legislation’s treatment of income and gain as ordinary income for services for federal tax purposes may affect the manner in which state and local jurisdictions treat these items. For example, as a result of the legislation, the incentive allocation may be treated as New York source income, on which a nonresident of New York State is subject to tax, and may also become subject to the 4% New York City unincorporated business tax.