Client Alert: Taxation of Carried Interests

December 14, 2009

We previously advised our clients that Congress was considering legislation that would change the tax treatment of so-called “back-end interests” or “profits interests” or “carried interests.” These types of interests generally are held by the general partners or managers of investment partnerships and limited liability companies, including real estate investment syndications and other investment funds, as a method of participation in the performance of the fund after investors receive a priority return. On December 9, 2009, the House of Representatives approved its version of the Tax Extenders Act of 2009 (H.R. 4213), which includes a provision regarding these types of interests. This change in the law was approved by the House in order to raise revenue to fund the extension of certain expiring tax cuts in the bill. If the Senate also approves this provision as part of any final tax cut extension bill, the President is expected to sign the bill into law.

Under this new provision, all income from an “investment services partnership interest” or “ISPI” will be taxable as ordinary income, without regard to whether that income arises due to an allocation of income, a distribution or a sale of the ISPI. In addition, these amounts generally will be treated as “self-employment” income, and therefore will be subject to payroll tax withholding for Social Security and Medicare under FICA.

An ISPI generally includes any partnership interest (including an interest in any entity, such as a limited liability company, taxable as a partnership) if that interest is issued to a person or related party who, at the time of issuance, is reasonably expected to provide a substantial quantity of any of the following services regarding assets held by the partnership:

- advising as to the advisability of investing in, purchasing or selling any “specified asset”;
- managing, acquiring or disposing of any “specified asset”;
- arranging financing with respect to acquiring any “specified asset”; or
- any activity in support of any of the services described above.

The term “specified asset” means any (i) “security”; (ii) real estate held for rental or investment; (iii) interest in a partnership; (iv) “commodity”; or (v) option or derivative contract with respect to any of the foregoing assets. The term “security” means any (i) corporate stock; (ii) interest in a widely held or publicly traded partnership or trust; (iii) note, bond, debenture or other evidence of indebtedness; (iv) interest rate, currency or equity notional principal contract; or (v) derivative contract or other hedging instrument with respect to any of the foregoing assets. The term “commodity” means any (i) actively traded commodity; (ii) notional principal contract with respect to an actively traded commodity; or (iii) derivative contract or other hedging instrument with respect to any of the foregoing assets.

An interest in a partnership generally will be excluded from being an ISPI if that interest was purchased on the same terms as unrelated, non-service providing investors and the allocations to these other interests are significant compared to the allocations to the interest held by the service provider or a related party. These interests may not be purchased, however, with proceeds of any loans from, or loans guaranteed by, the partnership or any partner or any of their related parties.

These new rules apply to an allocation, distribution or disposition occurring after December 31, 2009, regardless of the date of issuance of the ISPI. In other words, these new income tax provisions do not have any “grandfather” clause exception nor do they otherwise exclude from their application any currently outstanding ISPI.

For many clients who manage real estate investment syndications or other investment funds, these new rules will create a considerable increase in the amount of income tax payable by the general partner or manager at the time of sale or liquidation of the assets of the fund. The income allocated to the general partner or manager, including gain on sale of an interest in the fund, will be taxable at ordinary income tax rates, which currently is up to a federal rate of 35%. In addition, the general partner or manager also will be subject to additional tax for Medicare withholding, which currently is at a rate equal to 2.9% (half of which is deductible). Further, if other employment income of the general partner or manager has not exceeded the wage base cap for Social Security withholding (currently $106,800), then Social Security withholding also will apply up to the wage base cap, which currently is at a rate equal to 12.4% (half of which is deductible). On the other hand, under current law, income related to a “carried interest” that qualifies as long-term capital gain—as opposed to being treated as ordinary income as required in all cases under the proposed law—is taxed at the current maximum federal rate of 15%, and no Medicare or Social Security withholding applies to this income.

If you want to take action regarding this legislation, consider contacting your Senators and urge them to oppose the proposal to tax all income from “carried interests” as ordinary income. If you are concerned with this issue and are an Illinois resident, here are the links for our Senators: Richard Durbin and Roland Burris. If you're a resident of another state, here's a link through which you can reach all Senators: U.S. Senate.

If you have any questions, please contact Richard E. Aderman or Anthony R. Licata.

Pursuant to regulations governing practice before the Internal Revenue Service, unless expressly stated otherwise, any tax advice contained herein cannot be used, and is not intended to be used, by a taxpayer for (i) the purpose of avoiding tax penalties that may be imposed on the taxpayer under the Internal Revenue Code or (ii) the promotion or marketing of any tax-related matter or program.