Carried Interest Tax Legislation Suddenly Appears and Moves Forward

Tucked into the Tax Extenders Act of 2009 (H.R. 4213), is a provision targeted at partnership interests held by partners providing services.

This proposal seems to be the same proposal offered by Congressman Sandy Levin from the 12th District of Michigan in H.R. 1935 which has been sitting in Committee [See prior post: Carried Interest Tax Legislation.

H.R. 4213 flew through the legislative process of the House of Representatives. It was introduced on December 7, 2009 and passed by the House on December 9, mostly along party lines. The Carried Interest Tax is one of several dozen changes to the tax code included in the bill.

The text of the relevant section of the bill:

TITLE VI–OTHER REVENUE PROVISIONS

Subtitle A–Partnership Interests Held by Partners Providing Services

SEC. 601. PARTNERSHIP INTERESTS TRANSFERRED IN CONNECTION WITH PERFORMANCE OF SERVICES.

(a) Modification to Election To Include Partnership Interest in Gross Income in Year of Transfer- Subsection (c) of section 83 is amended by redesignating paragraph (4) as paragraph (5) and by inserting after paragraph (3) the following new paragraph:

‘(4) PARTNERSHIP INTERESTS- Except as provided by the Secretary, in the case of any transfer of an interest in a partnership in connection with the provision of services to (or for the benefit of) such partnership–

‘(A) the fair market value of such interest shall be treated for purposes of this section as being equal to the amount of the distribution which the partner would receive if the partnership sold (at the time of the transfer) all of its assets at fair market value and distributed the proceeds of such sale (reduced by the liabilities of the partnership) to its partners in liquidation of the partnership, and

‘(B) the person receiving such interest shall be treated as having made the election under subsection (b)(1) unless such person makes an election under this paragraph to have such subsection not apply.’.

(b) Conforming Amendment- Paragraph (2) of section 83(b) is amended by inserting ‘or subsection (c)(4)(B)’ after ‘paragraph (1)’.

(c) Effective Date- The amendments made by this section shall apply to interests in partnerships transferred after the date of the enactment of this Act.

SEC. 602. INCOME OF PARTNERS FOR PERFORMING INVESTMENT MANAGEMENT SERVICES TREATED AS ORDINARY INCOME RECEIVED FOR PERFORMANCE OF SERVICES.

(a) In General- Part I of subchapter K of chapter 1 is amended by adding at the end the following new section:

‘SEC. 710. SPECIAL RULES FOR PARTNERS PROVIDING INVESTMENT MANAGEMENT SERVICES TO PARTNERSHIP.

‘(a) Treatment of Distributive Share of Partnership Items- For purposes of this title, in the case of an investment services partnership interest–

‘(1) IN GENERAL- Notwithstanding section 702(b)–

‘(A) any net income with respect to such interest for any partnership taxable year shall be treated as ordinary income, and

‘(B) any net loss with respect to such interest for such year, to the extent not disallowed under paragraph (2) for such year, shall be treated as an ordinary loss.

All items of income, gain, deduction, and loss which are taken into account in computing net income or net loss shall be treated as ordinary income or ordinary loss (as the case may be).

‘(2) TREATMENT OF LOSSES-

‘(A) LIMITATION- Any net loss with respect to such interest shall be allowed for any partnership taxable year only to the extent that such loss does not exceed the excess (if any) of–

‘(i) the aggregate net income with respect to such interest for all prior partnership taxable years, over

‘(ii) the aggregate net loss with respect to such interest not disallowed under this subparagraph for all prior partnership taxable years.

‘(B) CARRYFORWARD- Any net loss for any partnership taxable year which is not allowed by reason of subparagraph (A) shall be treated as an item of loss with respect to such partnership interest for the succeeding partnership taxable year.

‘(C) BASIS ADJUSTMENT- No adjustment to the basis of a partnership interest shall be made on account of any net loss which is not allowed by reason of subparagraph (A).

‘(D) PRIOR PARTNERSHIP YEARS- Any reference in this paragraph to prior partnership taxable years shall only include prior partnership taxable years to which this section applies.

‘(3) NET INCOME AND LOSS- For purposes of this section–

‘(A) NET INCOME- The term ‘net income’ means, with respect to any investment services partnership interest for any partnership taxable year, the excess (if any) of–

‘(i) all items of income and gain taken into account by the holder of such interest under section 702 with respect to such interest for such year, over

‘(ii) all items of deduction and loss so taken into account.

‘(B) NET LOSS- The term ‘net loss’ means, with respect to such interest for such year, the excess (if any) of the amount described in subparagraph (A)(ii) over the amount described in subparagraph (A)(i).

‘(b) Dispositions of Partnership Interests-

‘(1) GAIN- Any gain on the disposition of an investment services partnership interest shall be treated as ordinary income and shall be recognized notwithstanding any other provision of this subtitle.

‘(2) LOSS- Any loss on the disposition of an investment services partnership interest shall be treated as an ordinary loss to the extent of the excess (if any) of–

‘(A) the aggregate net income with respect to such interest for all partnership taxable years, over

‘(B) the aggregate net loss with respect to such interest allowed under subsection (a)(2) for all partnership taxable years.

‘(3) DISPOSITION OF PORTION OF INTEREST- In the case of any disposition of an investment services partnership interest, the amount of net loss which otherwise would have (but for subsection (a)(2)(C)) applied to reduce the basis of such interest shall be disregarded for purposes of this section for all succeeding partnership taxable years.

‘(4) DISTRIBUTIONS OF PARTNERSHIP PROPERTY- In the case of any distribution of property by a partnership with respect to any investment services partnership interest held by a partner–

‘(A) the excess (if any) of–

‘(i) the fair market value of such property at the time of such distribution, over

‘(ii) the adjusted basis of such property in the hands of the partnership,

shall be taken into account as an increase in such partner’s distributive share of the taxable income of the partnership (except to the extent such excess is otherwise taken into account in determining the taxable income of the partnership),

‘(B) such property shall be treated for purposes of subpart B of part II as money distributed to such partner in an amount equal to such fair market value, and

‘(C) the basis of such property in the hands of such partner shall be such fair market value.

Subsection (b) of section 734 shall be applied without regard to the preceding sentence.

‘(5) APPLICATION OF SECTION 751- In applying section 751(a), an investment services partnership interest shall be treated as an inventory item.

‘(c) Investment Services Partnership Interest- For purposes of this section–

‘(1) IN GENERAL- The term ‘investment services partnership interest’ means any interest in a partnership which is held (directly or indirectly) 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 with respect to assets held (directly or indirectly) by the partnership:

‘(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).

For purposes of this paragraph, the term ‘specified asset’ means securities (as defined in section 475(c)(2) without regard to the last sentence thereof), real estate held for rental or investment, interests in partnerships, commodities (as defined in section 475(e)(2)), or options or derivative contracts with respect to any of the foregoing.

‘(2) EXCEPTION FOR CERTAIN CAPITAL INTERESTS-

‘(A) IN GENERAL- In the case of any portion of an investment services partnership interest which is a qualified capital interest, all items of income, gain, loss, and deduction which are allocated to such qualified capital interest shall not be taken into account under subsection (a) if–

‘(i) allocations of items are made by the partnership to such qualified capital interest in the same manner as such allocations are made to other qualified capital interests held by partners who do not provide any services described in paragraph (1) and who are not related to the partner holding the qualified capital interest, and

‘(ii) the allocations made to such other interests are significant compared to the allocations made to such qualified capital interest.

‘(B) SPECIAL RULE FOR NO OR INSIGNIFICANT ALLOCATIONS TO NONSERVICE PROVIDERS- To the extent provided by the Secretary in regulations or other guidance, in any case in which the requirements of subparagraph (A)(ii) are not satisfied, items of income, gain, loss, and deduction shall not be taken into account under subsection (a) to the extent that such items are properly allocable under such regulations or other guidance to qualified capital interests.

‘(C) SPECIAL RULE FOR DISPOSITIONS- In the case of any investment services partnership interest any portion of which is a qualified capital interest, subsection (b) shall not apply to so much of any gain or loss as bears the same proportion to the entire amount of such gain or loss as–

‘(i) the distributive share of gain or loss that would have been allocable to the qualified capital interest under subparagraph (A) if the partnership sold all of its assets immediately before the disposition, bears to

‘(ii) the distributive share of gain or loss that would have been so allocable to the investment services partnership interest of which such qualified capital interest is a part.

‘(D) QUALIFIED CAPITAL INTEREST- For purposes of this paragraph, the term ‘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 (determined without regard to section 752(a)) ,

‘(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.

The qualified capital interest shall be reduced by distributions from the partnership with respect to such interest for taxable years to which this section applies and by the excess (if any) of the amount described in clause (iii)(II) over the amount described in clause (iii)(I).

‘(E) TREATMENT OF CERTAIN LOANS-

‘(i) PROCEEDS OF PARTNERSHIP LOANS NOT TREATED AS QUALIFIED CAPITAL INTEREST OF SERVICE PROVIDING PARTNERS- For purposes of this paragraph, an investment services partnership interest shall not be treated as a qualified capital interest to the extent that such interest is acquired in connection with the proceeds of any loan or other advance made or guaranteed, directly or indirectly, by any other partner or the partnership (or any person related to any such other partner or the partnership).

‘(ii) REDUCTION IN ALLOCATIONS TO QUALIFIED CAPITAL INTERESTS FOR LOANS FROM NONSERVICE PROVIDING PARTNERS TO THE PARTNERSHIP- For purposes of this paragraph, any loan or other advance to the partnership made or guaranteed, directly or indirectly, by a partner not providing services described in paragraph (1) to the partnership (or any person related to such partner) shall be taken into account in determining the qualified capital interests of the partners in the partnership.

‘(3) RELATED PERSONS- A person shall be treated as related to another person if the relationship between such persons would result in a disallowance of losses under section 267 or 707(b).

‘(d) Other Income and Gain in Connection With Investment Management Services-

‘(1) IN GENERAL- If–

‘(A) a person performs (directly or indirectly) investment management services for any entity,

‘(B) such person holds (directly or indirectly) a disqualified interest with respect to such entity, and

‘(C) the value of such interest (or payments thereunder) is substantially related to the amount of income or gain (whether or not realized) from the assets with respect to which the investment management services are performed,

any income or gain with respect to such interest shall be treated as ordinary income. Rules similar to the rules of subsection (c)(2) shall apply for purposes of this subsection.

‘(2) DEFINITIONS- For purposes of this subsection–

‘(A) DISQUALIFIED INTEREST-

‘(i) IN GENERAL- The term ‘disqualified interest’ means, with respect to any entity–

‘(I) any interest in such entity other than indebtedness,

‘(II) convertible or contingent debt of such entity,

‘(III) any option or other right to acquire property described in subclause (I) or (II), and

‘(IV) any derivative instrument entered into (directly or indirectly) with such entity or any investor in such entity.

‘(ii) EXCEPTIONS- Such term shall not include–

‘(I) a partnership interest,

‘(II) except as provided by the Secretary, any interest in a taxable corporation, and

‘(III) except as provided by the Secretary, stock in an S corporation.

‘(B) TAXABLE CORPORATION- The term ‘taxable corporation’ means–

‘(i) a domestic C corporation, or

‘(ii) a foreign corporation substantially all of the income of which is–

‘(I) effectively connected with the conduct of a trade or business in the United States, or

‘(II) subject to a comprehensive foreign income tax (as defined in section 457A(d)(2)).

‘(C) INVESTMENT MANAGEMENT SERVICES- The term ‘investment management services’ means a substantial quantity of any of the services described in subsection (c)(1).

‘(e) Regulations- The Secretary shall prescribe such regulations or other guidance as is necessary or appropriate to carry out the purposes of this section, including regulations or other guidance to–

‘(1) provide modifications to the application of this section (including treating related persons as not related to one another) to the extent such modification is consistent with the purposes of this section,

‘(2) prevent the avoidance of the purposes of this section, and

‘(3) coordinate this section with the other provisions of this title.

‘(f) Cross Reference- For 40 percent penalty on certain underpayments due to the avoidance of this section, see section 6662.’.

(b) Income From Investment Services Partnership Interests Not Treated as Qualifying Income of Publicly Traded Partnerships- Subsection (d) of section 7704 is amended by adding at the end the following new paragraph:

‘(6) INCOME FROM INVESTMENT SERVICES PARTNERSHIP INTERESTS NOT QUALIFIED-

‘(A) IN GENERAL- Items of income and gain shall not be treated as qualifying income if such items are treated as ordinary income by reason of the application of section 710 (relating to special rules for partners providing investment management services to partnership).

‘(B) SPECIAL RULES FOR CERTAIN PARTNERSHIPS-

‘(i) CERTAIN PARTNERSHIPS OWNED BY REAL ESTATE INVESTMENT TRUSTS- Subparagraph (A) shall not apply in the case of a partnership which meets each of the following requirements:

‘(I) Such partnership is treated as publicly traded under this section solely by reason of interests in such partnership being convertible into interests in a real estate investment trust which is publicly traded.

‘(II) 50 percent or more of the capital and profits interests of such partnership are owned, directly or indirectly, at all times during the taxable year by such real estate investment trust (determined with the application of section 267(c)).

‘(III) Such partnership meets the requirements of paragraphs (2), (3), and (4) of section 856(c).

‘(ii) CERTAIN PARTNERSHIPS OWNING OTHER PUBLICLY TRADED PARTNERSHIPS- Subparagraph (A) shall not apply in the case of a partnership which meets each of the following requirements:

‘(I) Substantially all of the assets of such partnership consist of interests in one or more publicly traded partnerships (determined without regard to subsection (b)(2)).

‘(II) Substantially all of the income of such partnership is ordinary income or section 1231 gain (as defined in section 1231(a)(3)).

‘(C) TRANSITIONAL RULE- In the case of a partnership which is a publicly traded partnership on the date of the enactment of this paragraph, subparagraph (A) shall not apply to any taxable year of the partnership beginning before the date which is 10 years after the date of the enactment of this paragraph.’.

(c) Imposition of Penalty on Underpayments-

(1) IN GENERAL- Subsection (b) of section 6662, as amended by section 512, is amended by inserting after paragraph (6) the following new paragraph:

‘(7) The application of subsection (d) of section 710 or the regulations prescribed under section 710(e) to prevent the avoidance of the purposes of section 710.’.

(2) AMOUNT OF PENALTY-

(A) IN GENERAL- Section 6662, as amended by section 512, is amended by adding at the end the following new subsection:

‘(j) Increase in Penalty in Case of Property Transferred for Investment Management Services- In the case of any portion of an underpayment to which this section applies by reason of subsection (b)(7), subsection (a) shall be applied with respect to such portion by substituting ‘40 percent’ for ‘20 percent’.’.

(B) CONFORMING AMENDMENTS- Subparagraph (B) of section 6662A(e)(2) is amended–

(i) by striking ‘section 6662(h)’ and inserting ‘subsection (h) or (i) of section 6662’, and

(ii) by striking ‘GROSS VALUATION MISSTATEMENT PENALTY’ in the heading and inserting ‘CERTAIN INCREASED UNDERPAYMENT PENALTIES’.

(3) SPECIAL RULES FOR APPLICATION OF REASONABLE CAUSE EXCEPTION- Subsection (c) of section 6664 is amended–

(A) by redesignating paragraphs (2) and (3) as paragraphs (3) and (4), respectively,

(B) by striking ‘paragraph (2)’ in paragraph (4), as so redesignated, and inserting ‘paragraph (3)’, and

(C) by inserting after paragraph (1) the following new paragraph:

‘(2) SPECIAL RULE FOR UNDERPAYMENTS ATTRIBUTABLE TO INVESTMENT MANAGEMENT SERVICES-

‘(A) IN GENERAL- Paragraph (1) shall not apply to any portion of an underpayment to which this section applies by reason of subsection (b)(7) unless–

‘(i) the relevant facts affecting the tax treatment of the item are adequately disclosed,

‘(ii) there is or was substantial authority for such treatment, and

‘(iii) the taxpayer reasonably believed that such treatment was more likely than not the proper treatment.

‘(B) RULES RELATING TO REASONABLE BELIEF- Rules similar to the rules of subsection (d)(3) shall apply for purposes of subparagraph (A)(iii).’.

(d) Income and Loss From Investment Services Partnership Interests Taken Into Account in Determining Net Earnings From Self-Employment-

(1) INTERNAL REVENUE CODE- Section 1402(a) is amended by striking ‘and’ at the end of paragraph (16), by striking the period at the end of paragraph (17) and inserting ‘; and’, and by inserting after paragraph (17) the following new paragraph:

‘(18) notwithstanding the preceding provisions of this subsection, in the case of any individual engaged in the trade or business of providing services described in section 710(c)(1) with respect to any entity, any amount treated as ordinary income or ordinary loss of such individual under section 710 with respect to such entity shall be taken into account in determining the net earnings from self-employment of such individual.’.

(2) SOCIAL SECURITY ACT- Section 211(a) of the Social Security Act is amended by inserting after paragraph (16) the following new paragraph:

‘(17) Notwithstanding the preceding provisions of this subsection, in the case of any individual engaged in the trade or business of providing services described in section 710(c)(1) of the Internal Revenue Code of 1986 with respect to any entity, any amount treated as ordinary income or ordinary loss of such individual under section 710 of such Code with respect to such entity shall be taken into account in determining the net earnings from self-employment of such individual.’.

(e) Conforming Amendments-

(1) Subsection (d) of section 731 is amended by inserting ‘section 710(b)(4) (relating to distributions of partnership property),’ after ‘to the extent otherwise provided by’.

(2) Section 741 is amended by inserting ‘or section 710 (relating to special rules for partners providing investment management services to partnership)’ before the period at the end.

(3) The table of sections for part I of subchapter K of chapter 1 is amended by adding at the end the following new item:

‘Sec. 710. Special rules for partners providing investment management services to partnership.’.

(f) Effective Date-

(1) IN GENERAL- Except as otherwise provided in this subsection, the amendments made by this section shall apply to taxable years ending after December 31, 2009.

(2) PARTNERSHIP TAXABLE YEARS WHICH INCLUDE EFFECTIVE DATE- In applying section 710(a) of the Internal Revenue Code of 1986 (as added by this section) in the case of any partnership taxable year which includes December 31, 2009, the amount of the net income referred to in such section shall be treated as being the lesser of the net income for the entire partnership taxable year or the net income determined by only taking into account items attributable to the portion of the partnership taxable year which is after such date.

(3) DISPOSITIONS OF PARTNERSHIP INTERESTS- Section 710(b) of the Internal Revenue Code of 1986 (as added by this section) shall apply to dispositions and distributions after December 31, 2009.

(4) OTHER INCOME AND GAIN IN CONNECTION WITH INVESTMENT MANAGEMENT SERVICES- Section 710(d) of such Code (as added by this section) shall take effect on January 1, 2010.

(5) PUBLICLY TRADED PARTNERSHIPS- The amendment made by subsection (b) shall apply to taxable years beginning after December 31, 2009.

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