On April 2, 2009, Congressman Sander Levin (D-Mich.), a member of the House Ways and Means Committee, introduced in the U.S. House of Representatives "carried interest tax reform legislation" that, among other things, generally treats income with respect to "carried interests" as ordinary income (rather than capital gain), and therefore subjects such income to federal income tax at ordinary income tax rates rather than preferred capital gains tax rates (the "Proposed Legislation"). This legislation follows similar carried interest legislation introduced in the past. Although primarily intended to target managers of traditional investment funds (including real estate investment funds) that receive a share of the fund's profits in exchange for advisory or managerial services, the Proposed Legislation, as currently drafted, is very broad in scope and generally applies, in the case of any person providing substantial advisory services, to any partnership interest issued to such service provider by a partnership holding stock, securities, rental or investment real estate, commodities and/or other specified assets. Accordingly, the Proposed Legislation, if enacted, could potentially impact an even broader range of taxpayers.

Since the Proposed Legislation has only recently been introduced, modifications are likely. However, the Proposed Legislation is comprehensive in scope and addresses certain concerns raised about previous Congressional attempts to tax carried interests. We will continue to monitor new developments in the weeks and months to follow. If you have questions or would like additional information about the Proposed Legislation, please contact one of the authors or the Reed Smith attorney with whom you regularly work.

Taxation of Fund Manager Compensation Under Current Law

Most private investment funds are organized as entities that are treated as partnerships for federal tax purposes. Most fund managers receive, in exchange for advisory and managerial services undertaken on behalf of the fund, an interest in the partnership (i.e., a "carried interest") pursuant to which they are entitled to some designated share of the profits of the fund (in the case of hedge funds and private equity funds, typically 10–20 percent). In the case of many investment partnerships, this profit share is frequently subject to fund investors achieving specified returns (e.g., hurdle rates) and/or clawbacks. Additionally, an annual management fee equal to a specified percentage (e.g., 1–2 percent per annum) of contributed or committed capital is usually included as a component of remuneration for fund managers, and is already taxed at ordinary rates.

Under current law, the holder of a carried interest has a number of highly favorable federal tax benefits, including: (i) the character of income and gain with respect to the carried interest is determined at the partnership level, and therefore, gains from the sale of capital assets held by a fund for more than one year generally would be taxable under the preferential tax rates applicable to capital gain (the federal long-term capital gain rate is currently 15 percent, plus applicable state and local tax), rather than the tax rates applicable to ordinary income (the maximum marginal federal tax rate is currently 35 percent, plus applicable state and local tax); (ii) there is generally no taxable income required to be reported by the fund manager at the time the carried interest is issued (even though carried interests generally are considered to have "value" from a non-tax perspective); and (iii) taxable income is only recognized when taxable gains or profits are recognized by the partnership and allocated to the holder of the carried interest.

Highlights of the Proposed Legislation

Income from Carried Interests Taxed at Ordinary Income Rates: Under the Proposed Legislation, among other things, (i) any allocation of net income or net loss with respect to an "investment services partnership interest" (as described below) generally would be treated as ordinary income or loss (even if the income giving rise to such income is otherwise capital gain at the partnership level), (ii) allocations of net loss with respect to such interest generally would be subject to certain limitations, (iii) gain or loss on a disposition of such interest generally would be treated as ordinary income or loss (and, in the case of losses, subject to certain limitations), and (iv) "built-in gain" with respect to appreciated property (i.e., the excess of the fair market value of such property over its adjusted tax basis) distributed to the holder of such interest generally would be treated as an increase to such holder's distributive share of partnership income.

An "investment services partnership interest" is any partnership interest held by any person if it was reasonably expected (at the time such person acquired such partnership interest) that such person (or certain related persons) would provide (directly or indirectly) a "substantial quantity" of any of the following: (i) advisory services on the acquisition or disposition of, or investment in, any "specified asset"; (ii) services related to managing, acquiring or disposing of any "specified asset"; (iii) arranging financing to acquire "specified assets"; and/or (iv) any activity in support of any of the foregoing ("Managerial or Advisory Services"). "Specified assets" are defined broadly to include most securities (particularly stock in corporations, or any note, bond, debenture or other evidence of indebtedness), rental or investment real estate, partnership interests, commodities, and options or derivatives of any of the foregoing. The Proposed Legislation does not provide guidance as to the level of Managerial or Advisory Services necessary to constitute a "substantial quantity" of such services.

These provisions, if enacted, generally would apply to (i) income and loss allocations for taxable years ending after, and (ii) dispositions and distributions occurring after, in each case, a yet-to-be designated date. Thus, it appears that, as currently drafted, the Proposed Legislation would apply to allocations, dispositions and distributions made after enactment with respect to existing partnerships (i.e., existing carried interests would not avoid the Proposed Legislation through a "grandfather provision").

Exception for Certain Qualified Capital Interests: Notwithstanding the above, allocations of net income and net loss for an investment services partnership interest that is a "qualified capital interest" generally would not be characterized as ordinary income or loss pursuant to the Proposed Legislation if such allocations are made in the same manner as such allocations are made to partners not providing Managerial or Advisory Services and the allocations made to such other partners are "significant" compared with the allocations made with respect to such qualified capital interest. The Proposed Legislation does not define the meaning of "significant" for this purpose. The Proposed Legislation would also provide a similar exception for a disposition of any portion of a qualified capital interest.

A "qualified capital interest" is that portion of a partner's interest in partnership capital attributable to: (i) the value of the cash and property contributed to the partnership in exchange for such interest, (ii) any amounts included in gross income as a result of such partner's initial receipt of such interest and (iii) in general, the cumulative amount of net income allocated to the partner for taxable years during which the Proposed Legislation applies. The amount of a qualified capital interest generally would be reduced by partnership distributions and, in general, the cumulative amount of net loss allocated to such partner for taxable years during which the Proposed Legislation applies.

Presumably, as a reaction to techniques discussed to avoid predecessors of the Proposed Legislation, the Proposed Legislation also provides that an investment services partnership interest would not be treated as a qualified capital interest to the extent that such interest is acquired in connection with any loan proceeds or other advance made or guaranteed, directly or indirectly, by any partner or the partnership (or by certain persons related to such partner or partnership).

Other Income and Gain in Connection with Managerial or Advisory Services: The Proposed Legislation would also treat certain "other" income or gain related to "disqualified interests" (as described below) as ordinary income if (i) a person performs (directly or indirectly) Managerial or Advisory Services for any entity, (ii) such person holds a "disqualified interest" in such entity and (iii) the value of such interest (or payments thereunder) is substantially related to the amount of income or gain (whether or not realized) from the assets with respect to which the Managerial or Advisory Services are performed.

A "disqualified interest" is, with regard to any entity, (i) any interest in such entity other than debt, (ii) convertible or contingent debt, (iii) an option or right to acquire property described in (i) or (ii) immediately above or (iv) any derivative instrument entered into (directly or indirectly) with such entity or any investor in such entity, but does not include a partnership interest or stock in (A) a domestic C corporation, (B) a foreign corporation substantially all of the income of which is subject to U.S. taxation or a comprehensive foreign income tax, or (C) except as provided by the Secretary of the Treasury (the "Secretary"), an S corporation.

Pursuant to a grant of regulatory authority, the Secretary would have the power to prescribe such regulations as are necessary or appropriate to carry out the purposes of the Proposed Legislation.

This provision, if enacted, generally would take effect on a yet-to-be designated date.

Income from Carried Interests is "Bad Income" for Publicly Traded Partnerships: In general, publicly traded partnerships (i.e., entities treated for federal income tax purposes as partnerships with interests that are publicly traded) are taxed as corporations for federal income tax purposes. Under existing law, however, this rule does not apply to a publicly traded partnership for any taxable year for which at least 90 percent of the partnership's income is "qualifying income" (generally speaking, passive income such as rents, royalties, dividends and interest). Under the Proposed Legislation, items of income or gain treated as ordinary income under the Proposed Legislation, as described above, generally would not be treated as qualifying income, thereby making it less likely that a publicly traded partnership holding investment services partnership interests would satisfy the 90 percent qualifying income exception. Accordingly, the Proposed Legislation would make it more likely that publicly traded partnerships holding investment services partnership interests would be treated as corporations for federal income tax purposes.

This provision, if enacted, would apply to taxable years ending after a yet-to-be designated date. However, for publicly traded partnerships existing as of the date of enactment, the Proposed Legislation provides a 10-year grandfather rule (i.e., it defers application of the "bad income rule" for a period of 10 years). In addition, there are certain exceptions to the "bad income rule," including one for publicly traded partnerships owned by, or convertible into, shares of real estate investment trusts.

Income and Loss from Investment Services Partnership Interests Treated as Net Earnings from Self-Employment: Under the Proposed Legislation, any income or loss treated as ordinary income or loss as a result of being attributable to an investment services partnership interest would be taken into account in determining net earnings from self employment, and therefore, subject to social security tax. This provision, if enacted, would apply to taxable years ending after a yet to be designated date.

Increased Penalties for Understatements Related to Certain Proposed Legislation Provisions: The Proposed Legislation has put a premium on compliance by substantially increasing penalties for underpayments that are related to disqualified interests and to the Secretary's regulatory authority with respect to the Proposed Legislation, respectively (each, as described above). Specifically, the traditional 20 percent substantial understatement penalty under Section 6662 of the Internal Revenue Code (the "Code") has been increased to a 40 percent penalty in the case of underpayments related to such provisions. Additionally, the reasonable cause exception under Section 6664(c) of the Code is not available with respect to such underpayments. This provision, if enacted, would apply to taxable years ending after a yet to be designated date.

Carried Interest's Value Equals Amount of Deemed Liquidating Distribution: Under the Proposed Legislation, for purposes of Section 83 of the Code, the value of any partnership interest received for services would be the amount (if any) the holder of such partnership interest would receive if, at the time of the transfer of such partnership interest, the partnership sold all of its assets at fair market value and distributed the proceeds (net of liabilities) to its partners in a liquidating distribution. Furthermore, the person receiving such interest would be treated as making an election under Section 83(b) of the Code (i.e., to treat as income includable in the year of transfer) unless such person explicitly opts out. This provision generally is consistent with (but not identical to) guidance issued by the Internal Revenue Service regarding the tax consequences associated with the issuance of carried interests (e.g., Revenue Procedure 2001-43, Revenue Procedure 93-27, Notice 2005-43 and Proposed Regulations Section 1.83-3), as well as the advice provided by most practitioners with regard to the issuance of such interests. This provision, if enacted, would apply to partnership interests transferred after the date of enactment.