Carried Interest Tax Increase Decried by Some, Supported by Others

By Leo Pircher, Founding Member, Pircher Nichols & Meeks: Carried interest is a financial stake in the profits of the enterprise given to a general partner in a limited partnership or managing member in a limited liability company after the limited partners or other members have received a specified return on their investments. Receipt of such interest is supposed to compensate for the risks undertaken by the general partner or manager in connection with the project.

On May 28, 2010, the House of Representatives passed a proposal to tax a portion of the income attributable to a carried interest as ordinary income. Carried interest is a financial stake in the profits of the enterprise given to a general partner in a limited partnership or managing member in a limited liability company after the limited partners or other members have received a specified return on their investments. Receipt of such interest is supposed to compensate for the risks undertaken by the general partner or manager in connection with the project. Under current federal law, most carried interest is taxed as capital gain, and therefore at a 15 percent rate, whereas as ordinary income, it would be taxed at a rate as high as 35 percent.

While the scope of the proposed legislation is broad, covering private equity, venture capital, oil and gas interests and real estate, the largest impact would be on real estate interests, since real estate partnerships and LLCs constitute about 46 percent of the affected parties. Not surprisingly, the proposal has engendered forceful opposition from those groups and their representatives, who argue that the new tax would cause the reduction of up to $27 billion per annum in new investment, result in the loss of tens of thousands of jobs and adversely impact the value of commercial real estate. The supporters have emphasized fairness and have indicated that the tax would provide a revenue source to pay for popular tax incentives (they suggest that the bill passed in May would produce about $24 billion of revenue over the next ten years).

The bill that passed the House in May provided that for individuals, 50 percent of a carried interest otherwise taxable as capital gain, would be taxed as ordinary income for tax years beginning after 2010 and before 2013 and 75 percent thereafter.

The bill was taken up by the Senate in June. After several failed efforts to move the bill forward, Senate Majority Leader Harry Reid announced on June 24, 2010 that the Senate would move on to other business.

So where are we now? Is the proposal to tax a carried interest as ordinary income dead? Not likely, though the final product is likely to be more friendly to carried interest holders than previous proposals. One possibility, of course, is to further pare back the percentage of a carried interest taxed as ordinary income. Another possibility would be to exclude certain categories of investment, such as real estate, from the tax. However, various congressmen and senators have objected to special treatment of any industry on the grounds of fairness.

The most important fix would be not to apply it retroactively by grandfathering all existing partnerships and LLC’s, at least as to their existing investments. Interests in future deals can be adjusted to take into account the new tax rules. However, short of an agreement among all the parties, there is nothing than can be done in existing entities to adjust the financial interests between the promoters and the passive investors to take the new tax rules into account.