CRS Looking at Tax on “Carried Interest” for Partnerships…Again

Posted on Tue, Mar 25, 2014 ©2021 Drucker & Scaccetti

Can anyone recall a year when ‘tax reform’ has not been a hot issue in Washington? Well, this year is no different. While most tax commentary leans toward no significant new tax laws to be passed in 2014, the fund manager issue has both sides of the aisle talking…again. Now the Congressional Research Service (CRS) is looking closely at competing carried interest proposals.


Controversy over how to properly tax a partner's "carried interest" has existed for several years and rose in prominence during Mitt Romney's 2012 presidential campaign. Proposals to alter its taxation have been repeatedly raised in Congress since 2007, including two recent proposals, one in President Obama's 2015 budget and the other in Rep. Dave Camp's "Tax Reform Act of 2014 Here, The Tax Warriors examine a CRS report that explains carried interests and analyzes how each of the two recent proposals would change their existing tax treatment.


Under current law, carried interests are taxed at the capital gain rate instead of as ordinary income. The current law treatment "follows from the long-standing principle that the distributions of a partnership should be taxed the same as underlying income.”


Besides reduced tax rates, carried interest (and other types of capital gains income) also benefits from deferral, in that it is not taxed until realized. Deferral generally increases in value with both the length of the deferral period and the taxpayer's marginal tax rate. Hedge fund managers can further benefit from deferral by electing to receive their compensation in shares of foreign-chartered funds. In addition to deferring tax as long as the money is held offshore, the returns on the investment can compound tax-free.


Many argue that the current law treatment of carried interests is a loophole that violates the economic principle of horizontal equity, meaning taxpayers with similar incomes should face similar tax burdens. According to this point of view, fund managers provide labor to the fund the same as other workers provide to their employers, so the fund manager and worker should be taxed similarly. However, others argue that changing the current treatment of carried interests could have a negative impact on investment and financial risk-taking.


The CRS report refers to the President's 2014 budget proposal as "call[ing] for the taxation of carried interest as ordinary income less compensation from "enterprise value." Enterprise value is conceptually similar to goodwill, that is, it represents the portion of the value of an investment services management partnership remaining after the present value of the future returns from fees and carried interest and the value of traditional capital assets are removed. The report notes the lack of consensus in how to properly account for enterprise value for tax purposes and states that the President's budget proposal "reflect[s] the position that enterprise value contains characteristics of both capital and ordinary income."


In his 2014 budget, President Obama called for taxing as ordinary income and subjecting to self-employment tax a partner's share of income on an "investment services partnership interest" (ISPI) in an investment partnership, regardless of the character of the income at the partnership level. An ISPI was defined in the accompanying Treasury Explanations (the "Green Book") as "a carried interest in an investment partnership that is held by a person who provides services to the partnership," and a partnership would be considered an investment partnership if substantially all of its assets are investment-type assets (certain securities, real estate, interests in partnerships, commodities, cash or cash equivalents, or derivative contracts with respect to those assets), but only if over half of the partnership's contributed capital is from partners in whose hands the interests constitute property not  held in connection with a trade or business. The Green Book further provides that if the partner who holds an ISPI contributes "invested capital" (i.e., money or other property) to the partnership, and such partner's invested capital is a qualified capital interest, income attributable to the invested capital would not be recharacterized. Similarly, the portion of any gain recognized on the sale of an ISPI that is attributable to the invested capital would be treated as capital gain. The proposal in the 2015 budget is identical to the 2014 proposal described in the CRS report.


House Ways and Means Committee Chairman Dave Camp (R-MI) has recently released his tax reform plan titled "The Tax Reform Act of 2014." Rep. Camp's plan also had a provision that would characterize a portion (calculated under a "recharacterization formula," see below) of any capital gain from certain partnership interests held in connection with the performance of services as ordinary income. The provision would apply to a partnership engaged in a trade or business conducted on a regular, continuous and substantial basis comprising: (1) raising or returning capital, (2) identifying, investing in, or disposing of other trades or businesses, and (3) developing such trades or businesses. Partnerships engaged in a real property trade or business would be exempt.


The recharacterization formula would treat a service partner's applicable share of the invested capital of the partnership as generating ordinary income by multiplying that share by a specified rate of return (the Federal long-term rate plus 10 percentage points), intended to approximate the compensation earned by the service partner for managing the capital of the partnership. The recharacterization amount would be determined, but not realized, on an annual basis (i.e., it's cumulative) and tracked over time. To the extent a service partner contributes capital to the partnership, the result would be less capital gain being characterized as ordinary income. Any distribution or gain from the sale of a partnership interest (i.e., a realization event) then would be treated as ordinary to the extent of the partner's recharacterization account balance for the tax year, and amounts in excess of the recharacterization account balance would be capital gain.


The difference in the impact from the two proposals is huge. The Joint Committee on Taxation (JCT) projected that the carried interest provision in the President's 2014 budget would raise $17.4 billion in revenue during the FY2014-FY2023 budget window, and the provision in Rep. Camp's plan would raise $3.1 billion over the same period.


There are several factors that contribute to this significant different in projected revenue. The first is that Rep. Camp's plan recharacterizes only a portion of the gain as ordinary income. It also does not appear that Rep. Camp's proposal would subject the recharacterized gain to self-employment tax.


The CRS report also discussed another potential approach-changing the tax treatment of some hedge funds organized as publicly traded partnerships (PTPs; i.e., partnerships whose interests are traded on an established exchange or in a secondary market). PTPs are generally treated as corporations for tax purposes and subject to corporation income tax, with two exceptions: one exception consists of partnerships with at least 90% of their gross income from passive investments (e.g., dividends and capital gains); and the second consists of those partnerships publicly traded on Dec. 17, '87, which can elect to retain partnership treatment by paying a tax of 3.5% of gross income from the active conduct of business.


In 2007, several Senators introduced a bill that would have taxed PTPs that provide investment advisory and related asset management services as though they were corporations. In other words, these investment PTPs would have had to pay the corporate income tax on their earnings, rather than pass those earnings through to be taxed only as the partners' individual income. However, the bill didn't advance beyond the Senate Finance Committee.


The same thing is likely to happen here with neither legislative proposal advancing this year. We will keep you informed and can run a model applying your facts to this complicated area of taxation.  As we have noted in past blog posts, please consult your tax advisor and don’t take on this difficult computation on your own.


At Drucker & Scaccetti, we are always prepared to help you with this or any other area of taxation.  Call on us whenever you have a tax or business-related question.


Topics: partnerships, Taxation, Tax reform, carried interest, dave camp, deferral, publicly traded partnerships, Obama

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