We saw in the Obama budget (A New Era of Responsibility) that the administration was looking to raise revenue by taxing the carried interest for private investment funds. I was waiting to see how that one line item in the budget might translate into actual legislation and a change in tax policy. Congressman Sandy Levin from the 12th District of Michigan introduced the first attempt: H.R. 1935.
The changes in H.R. 1935 are focused on taxing the carried interest only to the extent the fund managers did not have an underlying investment in the fund. The bill proposes a new section 710 to the Internal Revenue Code in Subchapter K. Any net income from an “investment services partnership interest” will be treated as ordinary income and any net loss will be treated as ordinary loss.
“Investment services partnership interest” means
any interest in a partnership which is held by any person if it was reasonably expected (at the time that such person acquired such interest) that such person (or any person related to such person) would provide (directly or indirectly) a substantial quantity of any of the following services:
(A) Advising as to the advisability of investing in, purchasing, or selling any specified asset.
(B) Managing, acquiring, or disposing of any specified asset.
(C) Arranging financing with respect to acquiring specified assets.
(D) Any activity in support of any service described in subparagraphs (A) through (C).
There is an exception for “qualified capital interest” which will not be converted to ordinary income or loss, so long as the income, gain, loss, or deduction allocated to the “qualified capital interest” is in the same manner as it is to other partners and that those allocations are significant.
“Qualified capital interest” means so much of a partner’s interest in the capital of the partnership as is attributable to:
(i) the fair market value of any money or other property contributed to the partnership in exchange for such interest,
(ii) any amounts which have been included in gross income under section 83 with respect to the transfer of such interest, and
(iii) the excess (if any) of–
(I) any items of income and gain taken into account under section 702 with respect to such interest for taxable years to which this section applies, over
(II) any items of deduction and loss so taken into account.
This would seem to prevent private investment fund managers from converting a management fee into a partnership interest in the fund. I have not figured out how this affects a performance-based promote allocation in a fund structure.
As the Congressman characterizes the legislation in his press release:
“The legislation clarifies that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates. As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation. The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested themselves in the partnership.”
Since the bill was only introduced last week, it is too early to start changing things to address the changes in this bill. The bill may not pass and it may end up looking very different after it goes through the legislative meat grinder.