The Carried Interest Battle Continues

Successful alternative investment managers are typically paid a performance fee or a share of profits, what is commonly known as a “carried interest”. This is an amount in excess of any return they may earn on account of their own invested capital. Carried interests are taxable to the recipient, but are characterized as pro-rata shares of flow through income allocated to them. This generally results in tax favored long or short term capital gains, or qualified dividend income being allocated to these managers.

The tax treatment of carried interest has been a much discussed topic in Congress over the past few years. There have been several proposals in the Senate to convert carried interest to ordinary income, subject to self-employment tax. Those opposing these proposals argue that the manager as a partner is entitled to capital gain treatment under the general rules for taxing partnerships whereby the characteristics of a partnership’s income, either ordinary income or capital gains, flow through to the partners.

On December 10, 2009, H.R. 4213, The Tax Extenders Act of 2009 was passed by the House of Representatives and referred to the Senate Finance Committee. This proposal would have converted carried interest profit, share dividends, interest, and short and long-term capital gain to ordinary income, subject to self-employment tax. It would have required affected investment fund managers to treat carried interest as ordinary income received in exchange for the performance of services to the extent it exceeded a reasonable return on invested capital.As a result, the reduced tax rate on qualified dividends and long-term capital gains would cease to apply. The change would convert capital gain, taxed at 15 percent, intoordinary income, taxed at rates as high as 35 percent, also causing the income to be subject to self-employment tax. While Congress sought to increase the tax rate of fund managers, they chose not to provide the investors/limited partners ordinary deductions commensurate with what would have essentially been an investment management expense. Under the proposal, the carried interest would not be treated as an expense or a separately stated item by the limited partners. The carried interest for investor partnerships would also not be subject to the 2% limitation on investment expenses. Under the Tax Extenders Bill of 2009, the changes in taxation of carried interests would have been effective for taxable years after 2009 even though the Obama administration had aimed for 2011 to be the target year.

In May 2010, the carried interest proposal was brought up again by the Senate. Four Senate Democrats favored an exemption from the carried interest legislation for venture capital firms.The House proposed that only 50% of the carried interest be treated as ordinary income for 2011 and 2012, and 75% be treated as ordinary income thereafter. The 2010 Senate vote failed 57-41 and the carried interest issue appeared to have concluded its battle in Congress. That was until September 12, 2011 when President Obama’s American Jobs Act was submitted to Congress. This renewed the proposal to convert carried interest to ordinary income subject to self-employment tax. If passed, the provision would have become effective on January 1, 2013 raising $14.8 billion through 2021. This proposal had significant support in the Super Committee until time ended this effort.

Will the carried interest issue be raised again in future budget and tax negotiations? Since the potential dollars raised under any meaningful change would be significant, look for the carried interest legislation to remain on Congress’s radar.