Carried Interests: To Tax or Not to Tax, That is the Question
Michael Fernhoff, Partner, Kaye Scholer LLP
Okay, so I cheated a little, but hopefully it drew your attention. It is not whether, but when and how it will be taxed. But let's back up.
Carried Interest Defined
What is a "carried interest?" This is the name of an interest that private equity and hedge fund managers receive. Most private equity and hedge funds are set up as limited partnerships or limited liability companies. (I will call both "partnerships" throughout.) Most funds are structured to give the investors back their original investment plus a rate of return. Thereafter, the remaining profits are shared between the managers and the investors, with managers generally receiving somewhere between 15% and 30%. This amount is the "carried interest." You may have heard that some funds are structured with a "two and twenty" interest. This means that the managers earn a two percent management fee and a 20% carried interest in profits above a certain threshold.
Current System of Taxation
Under current tax rules, the receipt of a carried interest will not result in taxation upon receipt if properly structured as a "profits interest." A "profits interest" is an interest in a partnership that will give the owner of the interest absolutely nothing if, on the day he or she receives the partnership interest, the partnership's assets were sold at fair market value and the proceeds were distributed to the partners in complete liquidation of the partnership. For example, you and I set up a partnership. You agree to be the money partner (thank you) and I agree to contribute nothing but to work hard to make the money grow (you're welcome). If you contribute $100x and the partnership agreement provides that upon liquidation you receive $100x, I will receive nothing if liquidated on day one. I therefore have a profits interest and will not be taxed on receipt. Although I receive value, in the form of the ability to share in future profits, I will not be taxed because I receive nothing under this "liquidation analysis." (This is different than the receipt of common stock from a corporation, an important consideration when choosing an entity for a new enterprise.)
As a partnership earns income, all partners are taxed in the same way. If the partnership earns long-term capital gains, all partners have long-term capital gains (currently taxed at 15%).
In an environment where fund managers are taxed at 15% on millions of dollars for providing their management services but a regular employee, commission worker or broker is being taxed at ordinary income tax rates of 35%, it is no wonder why some politicians have concluded that the system is inequitable.
Proposals for Change
If one did want to "fix" this problem, how would one go about it? There are two main proposals under consideration. First, one could tax the fund manager upon the receipt of the "profits interest." Alternatively, one could tax the income received at ordinary income tax rates.
Turning to taxation upon current receipt, the IRS has argued this in the past and (gulp) won! Yes, it has successfully argued that the receipt of a profits interest is taxable on receipt (unless subject to restrictions that can result in the deferral of taxation). So what's the problem?
The problem is that, much like the dog chasing the car, the IRS quickly realized that it did not know what to do with what it had caught. Taxation upon receipt raises all sorts of questions in the partnership context. If a partner is taxed upon receipt, how is he or she taxed when the unrealized income is actually realized (after all, he or she has already been taxed)? Do the other partners get a deduction for the compensation income? Should the basis in partnership assets be increased by the value allocated to the partner (this can happen on a transfer of an interest)? Succumbing to the inevitable, the IRS issued a revenue procedure and reverted back to the liquidation fiction in order to avoid all of these complexities.
That leaves the alternative that has been in the news during the last year. Most proposed legislation has suggested that a carried interest should not be taxable on receipt, but income thereafter received should be taxed as ordinary income.
This sounds simple, but it is actually as complex. First, should all people receiving a carried interest be taxed at ordinary rates? If you and I buy an apartment building and I agree to do the leasing for an interest in the appreciation, should I be taxed at ordinary income tax rates? What if I put some money in, but not as much as you? What if we both put in the same amount of money but you loan the partnership the difference? Should that change the character of my income? Why should a sole proprietor who puts in money but also provides services be taxed at capital gains when he or she sells, but not partners? Fortunately, I do not have to answer these questions.
Future Outlook
What will the future bring? As I mentioned above, there have been various proposals. The last proposal was included in last year's alternative minimum tax patch, but it was eventually stripped out.
This issue will resurface again for two reasons. First, and most importantly, the provision is seen as a revenue raiser, and Congress is always looking for revenue raisers. Second, there is a perceived inequity, although the perception may die as the economy does. There should be no action this year, it being an election year. However, the fun and games will begin in 2009, mainly because the Bush tax cuts expire in 2010, and my money is on adoption of something similar to the last proposal, assuming the Democrats retain control of Congress. (There goes simplification.)
So, keep using this time-honored structure for now. It still provides excellent tax benefits to persons who provide services to partnerships, whether or not your partnership is a Blackstone or simply a partnership between you and me.
Michael Fernhoff is a partner in the Los Angeles office of Kaye Scholer LLP, where he chairs the Los Angeles Tax Practice Group. Mr. Fernhoff has substantial experience in all aspects of federal income tax planning for limited liability companies and partnerships, including the planning and structuring of private equity, joint ventures and other similar arrangements, and can be reached at 310.788.1374 or mfernhoff@kayescholer.com.
Kaye Scholer is an international law firm with approximately 500 lawyers in eight offices around the world. Our global transaction and litigation capability covers a multitude of practices in areas including litigation, corporate, real estate, business reorganization, wills and estates and tax.