Under President Obama’'s fiscal year 2010 budget proposal, carried interest would be taxed as ordinary income beginning in 2011. No statutory language has yet been released, but based on statutory language proposed in 2007 and 2008 that may be used as a model for the administration's proposal, net income allocated to a fund’s general partner or any of its affiliates with respect to what has been referred to under certain of such proposals as an “investment services partnership interest” would generally be taxed at ordinary income tax rates, even if such net income is an allocation of a share of long-term capital gains that would otherwise be taxed at the lower capital gains rates. An “investment services partnership interest” includes any interest in a partnership that is held by any person who provides (directly or indirectly) a substantial quantity of investment advisory and/or management services to the partnership. The proposals generally contained an exception for capital interests acquired upon the contribution of invested capital, which would not include any type of loan made to a partner, directly or indirectly, by any other partner or by the partnership.
It is expected that any carried interest legislation would also tax income from management fee waiver programs, also known as “management profits interests.” A management profits interest is an indirect profits interest in a private equity fund that members of the investment management team receive in connection with a waiver of current management fees. The limited partners of the private equity fund contribute amounts equal to the waived management fees to fund what are in effect capital contributions to private equity fund investments on a pre-tax basis (i.e., notional capital contributions) on behalf of the management team. Upon realization of an investment, the management team generally will receive an amount equal to its notional capital contributions in such investment and proportionate profits thereon, in each case, only to the extent that the fund has available profits realized on the investment. Under the current tax law, it is intended that the return of these notional capital contributions and profits be converted into capital gains (assuming that the private equity fund earns capital gains). Management fee waiver programs are viewed as an effective tool to defer taxation of management fees and effectively convert management fee income to capital gains.
Under the proposed legislation described above, all profits associated with a management profits interest would be taxable at the higher ordinary income tax rates - both the notional capital contributions and the long term profits thereon. Accordingly, although the waiver may still defer taxes, it would not have the effect of converting management fee income to capital gains under such a proposal. On the other hand, if the management team receives the management fee income currently, pays ordinary income tax on such income, and invests those after-tax dollars (plus any required additional capital to fund their capital obligation to the private equity fund), profits earned on this cash investment would remain eligible for long-term capital gains treatment. Accordingly, the new tax proposal, if enacted, would significantly impact the overall analysis of whether it makes sense in existing private equity funds to continue to utilize management fee waiver programs, as the possibility of a higher effective tax rate must be added to the analysis of the other features of the management fee waiver program (tax deferral, the ability in effect to satisfy a capital commitment with pretax dollars (which reduces economic exposure to the private equity fund) and the need for the private equity fund to earn profits). Since decisions with respect to the utilization of these programs in existing private equity funds (including the application of waived management fees to new investments) may be made currently, it would be timely for management teams to begin the overall analysis now