Change in Carried Interest Legislation

Congress has proposed legislation touted as taxing partnership capital gain allocated to investment managers at ordinary income rates. The “carried interest” legislation as drafted is vastly broader, affecting interest holders in many existing partnerships, not just managers of private equity and other investment funds. The legislation would affect small businesses, family partnerships, corporate joint ventures and other partnerships that are not commonly thought to be the subject of the legislation.

No “carried interest” need be involved. No conversion of capital gain into ordinary income is required. It applies to corporations, who pay the same tax rate on both types of income. Taxpayers caught up in the legislation would be taxed at higher rates on their shares of partnership capital gains, be unable to deduct all or a portion of their share of partnership losses, be denied the use of common nonrecognition provisions (no tax free property distributions), and may find that they are subject to the 2.9% hospital insurance (“HI”) tax on a portion of their partnership income (if they are actively involved in the partnership’s business).

The legislation applies to any partner who renders substantial services to a partnership that owns “specified assets.” Specified assets include rental real estate, stock and securities, and partnership interests. Most tiered partnership arrangements are thus covered. Extremely broad related party rules greatly extend the proposal’s reach.

The proposal legislation contains two exceptions, both of which are difficult to satisfy. One is for partnership structures whose allocations are “straight up”, including allocations in all lower tier partnerships. A second is for allocations with respect to “qualified capital” of the service provider for partnerships which have unrelated partners who get the same allocations. This exception is unavailable for family partnerships (no unrelated partners) and many real estate partnerships (qualified capital is reduced by losses; partners with negative tax capital accounts have no qualified capital).

The following link contains a summary of the proposed legislation and several examples illustrating its unexpected consequences. Particular attention should be given to Examples 1 (family real estate partnership, all equal partners: losses denied, capital gains benefits curtailed), 2 (same, transfer of interest in divorce taxed), 3 (straight-up family operating business partnership, tiered structure: operating losses not deductible and converted to capital losses on disposition of business) and 5 (publicly-traded corporation, internal partnership: losses not deductible, gain triggered by “tax free” merger).

The legislation has not been enacted, and may be modified prior to passage. Moreover, the Treasury Department may ameliorate the impact of the rules through regulations. As currently drafted, however, the potential adverse impact of this proposal cannot be overstated. For more information click here.