On Friday, April 3, 2009, Rep. Sander Levin (D-Mich.) reintroduced a bill to tax carried interest capital gains at ordinary income rates. This bill is substantially similar to the version proposed by Rep. Levin in June 2007, although it goes further than the prior proposals in some important respects; the Obama administration 2010 budget proposes similar legislation. The House of Representatives passed the earlier versions of the bill, both in the fall of 2007 and the summer of 2008, but the legislation never progressed beyond that point.  

Key features of the proposal are:

Carried Interest Taxed at Ordinary Income Rates. As with the prior proposals, this bill would tax any income from an “investment services partnership interest” at ordinary rather than capital gains rates. It would also tax gains from the dispositions of such interests at ordinary rates. Going beyond earlier proposals, gains realized in transactions that would otherwise be tax-deferred (including, it appears, gifts) are also subject to tax at ordinary rates. As written, the bill would cover both carried interests and so-called “fee waiver” or “MPI” interests.

Interests Treated as Investment Services Partnership Interests. “Investment services partnership interests” are interests in a partnership held by a person if it was reasonably expected at the time the person acquired the interest that the person or a related party would provide a substantial quantity of advisory or management services, directly or indirectly, to the partnership with respect to “specified assets.” Specified assets generally consist of securities, rental and investment real estate, partnership interests, and commodities, as well as options and derivatives with respect to those assets.

Disqualified Interests. Income and gain from a “disqualified interest” is also treated as ordinary income. A disqualified interest is, in general, an interest in an entity the value of which is substantially related to the amount of income or gain generated by assets with respect to which investment management services are performed. Exceptions are provided for, among other things, interests in a taxable C corporation. Thus “founders stock” and similar interests would appear not to be covered. However, an interest in a non-U.S. corporation the income of which is not effectively connected with a U.S. trade or business or subject to a comprehensive income tax is a disqualified interest. The effect of this provision appears to be to shut down a PFIC-based structure that has been discussed in the press to substitute for partnership carried interests in offshore corporations not themselves subject to tax.  

Some Notable Points

  • Any amounts treated as ordinary income under the proposal would be subject to self-employment taxes for individual taxpayers.  
  • The legislative language no longer generally treats income as being derived from the performance of services (although the subsection heading still includes that characterization). If this change is intended, it would mean that the proposal would not have an adverse effect on the ECI or UBTI consequences to foreign and tax-exempt investors holding interests in carried interest vehicles.  
  • Income received by publicly traded partnerships from investment services partnership interests treated as ordinary income under the proposal (i.e., the Blackstone structure) would not be treated as qualifying income for purposes of the publicly traded partnership rules. This could result in publicly-traded investment manager partnerships being taxed as corporations. The draft proposal, however, contains a transition rule that would exempt partnerships “in existence” on the date of the enactment from the application of this new rule for ten years.  
  • The benefits of tax receivable agreements, which were entered into in connection with the IPOs of some publicly-traded investment managers and other businesses, would be curtailed by characterizing as ordinary income any gain with respect to the sale of partnership interests in a partnership that had entered into a tax receivable agreement with the seller.  
  • The proposal would codify the “profits interest” approach provided in IRS revenue procedures and draft proposed regulations for valuing interests in partnerships transferred in connection with the performance of services using a hypothetical liquidation. The proposal also provides that the recipient of the partnership interest will be treated as having made a Section 83(b) election, unless the recipient otherwise elects to have the Section 83(b) election not apply.

Treatment of Capital Interests. As with the earlier versions of the legislation, there is an exception from ordinary income treatment for reasonable returns on “qualified capital interests.” Under this rule, the service-provider partner would receive capital gains treatment on returns on capital to the extent of the similar returns received by non-service provider, unrelated limited partners. In addition, the rule characterizing gains from dispositions of investment service partnership interests as ordinary income would not apply to any portion of the gain attributable to a qualified capital interest.

The proposal defines a qualified capital interest as the portion of a partner’s interest in the capital of a partnership attributable to the amount of money or the fair market value of property contributed to the partnership in exchange for the interest. Expanding on the prior proposals, (A) any amounts the partner included in gross income with respect to the transfer of the interest and (B) cumulative net income and gain taken into account with respect to the interest for years to which the new law applies would also be treated as capital investments, but such amounts would be reduced by losses and distributions. A qualified capital interest does not include a capital interest acquired with the proceeds of a loan from or guaranteed by the partnership or a partner, thus cutting off another “work around” discussed in the press.

As with the prior carried interest proposals, this bill would clearly apply to managers of traditional buyout funds, real estate funds, and hedge funds that rely on carried interest allocation. Profits interests issued to employees in other kinds of businesses may not be caught by this legislation (largely because of the limiting definition of “specified assets”).

The provision for the effective date of this legislation is blank, the significance of which is not clear. The 2008 proposals would have been effective for taxable years ending after the date enacted. By contrast, the Obama administration’s budget proposal would be effective in 2011.

The legislative situation is extremely fluid, and it is difficult to predict the timing and outcome of various matters, including the effective date of any legislation that might be enacted. We will do our best to keep our clients and friends up to date on significant developments.