On April 3, 2009, Rep. Sander Levin (D-Mich.) introduced H.R. 1935, which amends several provisions of the Internal Revenue Code of 1986 to, among other things, change the character of the income attributable to an "investment services partnership interest" from capital gain to ordinary income. The proposal would impact partnership interests issued to managers of investment vehicles such as hedge funds and private equity funds, as well as employees of such investment vehicles that receive a profits interest or carried interest as part of their compensation. Under current law, the character of this income (either capital or ordinary) is determined at the partnership level and "passed" through to the individuals who hold the carried interests. If H.R. 1935 is enacted in its current form, the character of a substantial portion of the income of these individuals will shift from capital gain, which is currently taxed at the lower preferential federal tax rates (i.e., 15 percent), to ordinary income, taxable at the current federal marginal rate of 35 percent.

H.R. 1935 does not contain a specific effective date. However, the proposal generally provides that, if enacted, it will apply to taxable years ending after a yet-to-be-designated year. It is important to note that those provisions of H.R. 1935 recharacterizing income as ordinary income rather than capital gain, do not apply to (and therefore, do not change the current rules for) carried interests that do not qualify as "investment services partnership interests."

The changes proposed in H.R. 1935 have been proposed previously and the concept of taxing carried interests as ordinary income was part of President Obama's most recent budget proposal. Reed Smith will continue to monitor the progress of H.R. 1935 and analyze its potential impact. If you have any questions regarding H.R. 1935 or any other relevant issues, please contact one of the members of Reed Smith's executive compensation and employee benefits team listed below, or the Reed Smith attorney with whom you regularly work.