Policy Documents

Carried Interest Legislative Proposals and Enterprise Value Tax

Jack S. Levin, Donald E. Rocap, and William R. Welke –
November 1, 2010

Jack S. Levin, Donald E. Rocap, and William R. Welke are partners in the Chicago office of Kirkland & Ellis LLP. Levin is a lecturer in law at the Harvard Law School, and Levin and Rocap are also lecturers in law at the University of Chicago Law School. Levin (with the invaluable assistance of Rocap and Welke) is author of a one-volume treatise, Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions, and coauthor of a five-volume treatise, Mergers, Acquisitions, and Buyouts. The authors thank Stephen H. Butler of Kirkland & Ellis for his assistance in preparing this report.

This report examines a pending legislative proposal to change the code’s long-standing character-flow-through regime for a service partner who owns a carried interest in a partnership (or limited liability company) engaged in investment or real estate activities. The most recent versions of the House and Senate proposals would add new section 710, taxing a portion (between 50 and 75 percent) of those carried interest allocations as ordinary compensation income.

We first provide a brief description of proposed section 710. Second, we briefly describe several serious flaws in 710, principally stemming from the legislation’s staggering complexity; incompatibility with generally applicable tax principles; excessively broad, abstract, and incomprehensible rules, sub-rules, and definitions; and sweeping grants of regulatory power. And third, we focus on an aspect that is particularly unwise from both a tax and economic policy perspective: 710’s treatment of all the gain on disposition of a service partner’s carried interest in a partnership engaged in investment or real estate activities as 710 tainted and thus as 50 to 75 percent ordinary compensation income (depending on whether the House or Senate version prevails). This so-called enterprise value tax treats gain on disposition of such an interest in an investment or real estate partnership far more harshly than warranted by the logic for enacting 710 and far more harshly than disposition gain on either (a) a partnership engaged in any other business or (b) a C corporation engaged in any business (including investments or real estate).

If Congress chooses to enact 710 (hopefully only after curing the serious flaws described herein and ensuring that there are no other unintended consequences), the authors propose that 710 taint on gain from the disposition of such a partnership interest be limited (through invocation of expanded section 751 hot asset rules) to the amount of carried interest gain that would be allocated to the interest if the partnership sold its underlying investment or real estate assets at current value.