Federal Investment Tax Change Bill Worries Investors

Published November 1, 2007

On June 22, Rep. Sander Levin (D-MI) introduced a bill (HR 2834) that would drastically alter the taxation of carried interests held by managers of investment funds and real estate ventures.

These people often earn a significant portion of their returns through such carried interests, and some analysts fear the bill, if enacted, could reduce investment in important areas of the economy.

“Carried interests” are partnership interests received in exchange for services rather than a capital investment, and they are generally structured so the holder shares in future profits and appreciation of the venture. The holder does not share in any of the underlying value of the venture as of the date the partnership interest is granted.

Long-Settled Law

Under long-settled tax law, any income recognized by an entity that is treated as a partnership for federal income tax purposes retains its character as ordinary income or capital gain when it “flows through” and is taxed to the partners.

Thus the holder of a carried interest is entitled to capital gain treatment on the holder’s allocable share of any capital gain recognized by the partnership.

Furthermore, it has long been the case that the sale or other disposition of a carried interest–like the sale of any other partnership interest–generally gives rise to capital gain or loss.

This capital gain treatment is important because individuals are subject to a maximum federal income tax rate of 15 percent on long-term capital gains (capital gains on assets held for more than one year), while the maximum rate at which they are taxed on all other income is currently 35 percent.

Effective Tax Increase

Under HR 2834, any income that arises from a carried interest held by a person providing management, advisory, or certain other services to investment funds and real estate partnerships would be taxed as ordinary income. This includes the holder’s allocable share of any capital gain that is earned by the partnership and any gain recognized on the sale or other disposition of the carried interest.

The rationale behind HR 2834 is that investment fund managers receive their carried interests as compensation for services and thus should pay tax on the carried interests the same way the average American pays taxes on his or her wages.

Levin said in a June press statement, “Investment fund employees should not pay a lower rate of tax on their compensation for services than other Americans.”

Importance of Risk

While there has been extensive debate regarding the taxation of carried interests since the introduction of HR 2834, no clear consensus has emerged.

The sponsors of the bill argue ordinary income treatment of carried interests merely levels the playing field. Others say there is a fundamental difference between carried interests and other types of compensation paid for services.

Carried interests, they say, reflect an investment interest in the partnership, in that the amount and timing of any return depends on the success of the venture, which is never guaranteed. The holder of a carried interest is exposed to the risks of the underlying partnership investment in the same manner as one who put up capital for his partnership interest, so the holder of a carried interest should be entitled to the same tax treatment, they say.

Burden on Investment

Others argue HR 2834 will chill investment, often in areas that need it most.

In a July 31 Senate Finance Committee hearing, Bruce Rosenblum, managing director of the Carlyle Group and chairman of the Private Equity Council, warned, “There will be deals that don’t get done. There will be entrepreneurs that won’t get funded and turnarounds that won’t get undertaken.”

At the same hearing, real estate entrepreneur Adam Ifshin said if the legislation were enacted, “some development would still occur, but the material shift in the risk/reward trade-off for the developer would mean that fewer projects would be built … [and] underserved and given-up-for-dead locations [would be] far less appealing to developers because those deals are harder to put together and have greater risk associated with doing them.”

At a more basic level, some are concerned about the complexity HR 2834 would add to federal tax laws that are already well beyond the reach of the average citizen, and others have raised the commonly held viewpoint that it is rarely sound tax policy to single out specific industries for different treatment as HR 2834 does.

Need for Tax Certainty

U.S. Treasury Assistant Secretary for Tax Policy Eric Solomon told Finance Committee members the current tax treatment of carried interests “provides certainty to taxpayers in planning their transactions” and “was administrable by the IRS.”

Solomon warned, “We must be cautious about making significant changes to partnership tax rules that have worked successfully to promote and support entrepreneurship for many decades.”

Many others, including Senate Finance Committee Chairman Max Baucus (D-MT) and Finance Committee member John Kerry (D-MA), have echoed the sentiment that lawmakers should be cautious about enacting legislation that so dramatically alters well-worn tax principles.

In late July, Senate Finance Committee member Chuck Grassley (R-IA) said the private equity lobby had probably already managed to forestall any chances of the carried interest legislation being passed this year. But Charles Rangel (D-NY), one of the co-sponsors of HR 2834, has threatened to combine the carried interest legislation with an Alternative Minimum Tax reform proposal in an apparent attempt to make a threatened veto of HR 2834 by President George W. Bush more difficult.

Mark Saulino ([email protected]) is a partner in Dreier Stein & Kahan LLP’s Transactional Department in Santa Monica, California, whose practice focuses on business taxation. He is a frequent lecturer on corporate and tax law.