June 9, 2009

What Fund Managers and Fund Investors Need to Know About Carried Interest Tax Legislation

Arnold & Porter Advisory

By Charlotte M. Saxon

As many of you undoubtedly know, the tax treatment of "carried interests" has become a hot button issue in recent years, fueled by reports of the outsized earnings of certain hedge fund and private equity fund managers. Proposals to change this favorable treatment have, unlike many other proposed tax increases, generally been met with populist approval. A bill that would deny capital gain rates to fund managers' "carried interests" is currently pending in the House of Representatives, and proponents of this bill now have a clear ally in the White House, with President Obama having included a more broadly targeted version of this proposal in his Fiscal Year 2010 budget. 

It is difficult to predict whether or when, and in what form, any carried interest legislation might be enacted. On the one hand, some legislators who supported these proposals in prior years have more recently expressed a desire to defer any action on carried interests until the current economic situation improves, out of a concern that the impact on investment managers might derail the nascent stock market recovery. In addition, there are numerous technical issues and unintended consequences to making this sort of change to the taxation of partnerships and partners, some of which may be difficult to resolve. On the other hand, the likelihood of a bill being enacted this year or next may well be higher than in prior years, given the current dire need to raise revenues in politically palatable ways, coupled with the possibility that the lobbying groups that vigorously opposed these proposals in earlier years may now, in the current economic environment, have significantly diminished political capital to expend on this issue. On balance, most Washington watchers expect some form of carried interest legislation to be enacted this year or next.

In this article, we will briefly describe what is meant by a "carried interest" and the way that such interests are taxed under current law. We will then describe how the currently pending proposals would change that treatment. We conclude with some thoughts on what fund managers and investors should be thinking about now in order to be prepared should this or similar legislation be enacted.

Overview of "Carried Interests"

Most private domestic investment funds and many offshore funds are structured as partnerships. Typically, the manager (or an affiliated entity) of an investment fund serves as the general partner of the fund and makes an initial investment in the fund that is small relative to the investments being made by the outside investors, who are admitted as limited partners in the fund. The manager (or an affiliated entity), in return for managing the fund and its investment assets, usually receives, in addition to a periodic asset management fee, performance-based compensation—typically structured as a "carried interest" in the fund—entitling the manager to a percentage (often 20%) of the profits earned by the fund.1

Current Tax Benefits of Structuring the Manager's Compensation as a Carried Interest

As a general matter, investment funds that are characterized as partnerships for tax purposes are treated as "passthroughs." That is, the fund's taxable income and loss is computed and characterized at the fund level, but each partner includes and reports (and pays taxes on) its share of the fund's taxable income and loss as part of its own taxable income. The various components of a partnership's income generally retain their character when they are passed through to its partners. Therefore, if a partnership has long term capital gains, those gains are allocated among the partners, and each partner reports its share of those amounts on its own return as long term capital gains on which it pays tax at no higher than the maximum long term capital gain rate.2

Eligible for long term capital gain rates

Under current law, it is well-established that the manager's carried interest qualifies as a "partnership interest," and the manager qualifies as a "partner," even though the carried interest is issued in exchange only for services, and even though at issuance, the manager has no interest in the fund's capital. Therefore, to the extent that the profits of a fund are long term capital gains, the manager may report the amounts allocated to it with respect to its carried interest as long term capital gains eligible for favorable capital gain rates.

Exempt from employment taxes

In addition, for purposes of determining self-employment income, carry amounts allocated directly to an individual fund manager (or indirectly to the individual owners of a fund manager that is organized as a tax-passthrough entity) are treated under current law as investment income rather than self-employment income. As a result, these amounts are not subject to any self-employment taxes.3

Deduction equivalent available to fund investors without limitations

There is also a tax benefit for certain limited partners to structuring the general partner's performance-based compensation as a carried interest. For those funds that are considered for tax purposes to be "investors" as opposed to "traders," there are significant limitations on the ability of a limited partner who is an individual to deduct his or her share of fees paid to the general partner. However, the amount of partnership income or gain allocated to the general partner as its "carry" effectively reduces on a dollar for dollar basis the amount of taxable income and gains allocated to the limited partners, making the amount in effect fully deductible for all limited partners, including individuals, irrespective of whether the fund is a trader or an investor.

Current Proposals

On April 2, 2009, Representative Sander Levin (D—Michigan) introduced into the House of Representatives the latest version of the carried interest legislation. President Obama's budget includes a similar but broader proposal (although not expressed in statutory language and therefore not as detailed). This discussion will generally address only the provisions of the Levin Bill, given that it is more complete than President Obama's proposal; however, we will note where relevant the few areas where there appear to be material differences.

The Levin Bill would enact a new Internal Revenue Code Section—Section 710—which would generally apply to partnership profits interests received in exchange for providing only certain types of services—principally, investment advice and related services—relating only to certain types of assets—principally, securities, real estate and commodities.4

Under the bill, the receipt of the profits interest would, as under current law, generally not be a taxable event; however, any partnership income allocated to a carried interest that is covered by the bill would be taxed at ordinary rates, irrespective of the character of the income at the partnership level.5 Furthermore, the bill provides that such amounts would also, if allocated directly or indirectly to an individual, be subject to self-employment taxes.

In an effort not to unduly penalize the manager, the bill attempts to differentiate allocations to the manager on its "carried interest" (which are taxed at ordinary rates and subject to employment taxes) from allocations to the manager on the manager's "qualified invested capital" (which are not recharacterized as ordinary income and are not subject to employment taxes).

The bill also contains a number of provisions addressed at preventing obvious end runs around the statute by, for example, recharacterizing the gain on a sale of a carried interest, and treating certain funds that the manager might borrow to fund an investment in the fund as not being "qualified invested capital" for this purpose. The bill also includes a 40% penalty for any underpayment of tax arising from transactions involving certain statutorily defined "disqualified interests" or that arise from transactions that regulations to be promulgated describe as structured to avoid the impact of the new provision.

The Levin Bill does not yet have a proposed effective date6 , and there is no provision for grandfathering existing arrangements.

What Should Fund Managers and Investors Be Doing Now?

While no definitive action should be taken until the proposals have advanced further through the legislative process, it is advisable to consider the impact that these proposals (or similar legislation) would have on fund managers' and fund investors' particular situations, and to explore appropriate strategies that might be deployed.

1. Evaluation of additional costs that would be imposed on traditional carry arrangements.

First, one ought to try to quantify the actual cost that a fund manager would incur if carried interest legislation is enacted. This cost will depend significantly on the nature of the fund's investment activities. For example, those hedge funds that are traders with very high portfolio turnover may often have little if any long term capital gain and little unrealized gains, in which case the income tax cost of the proposal would not be material; whereas, private equity and venture capital funds typically generate almost exclusively long term capital gains, so that managers of these funds would, if carried interest legislation is enacted, bear significantly higher income tax costs on their carry.

Regardless of the nature of the fund's income, the manager who is an individual (or the individual owners of a management firm that is organized as a tax-passthrough) will feel the bite of the imposition of self-employment taxes on the carried interest.

2. Assessment of administrative burdens and uncertainty that would be imposed on traditional carry arrangements.

In addition, in evaluating the costs that would result from enactment of the proposal, one needs to consider the administrative burdens that may be imposed by the proposed legislation. In particular, distinguishing carried interest allocations (that will be taxed as ordinary income) from allocations that will be treated as returns on qualified invested capital (that will continue to receive capital gain treatment) will involve substantial uncertainty and complexity with regard to allocated but unwithdrawn carry.

For hedge funds, unwithdrawn incentive allocations are treated, under the economic terms of the fund agreement, the same as any other invested capital. However, in order to be treated as invested capital under the Levin Bill, the amounts would have to actually have been taxed—any portions of the manager's carry allocations that represent unrealized gains would not under the terms of the proposed legislation be treated as qualified invested capital for purposes of the statute (even though those amounts under the terms of the fund agreement are treated as capital and would earn a return). Thus, in addition to recharacterizing as ordinary income the explicit carry allocations, the application of the statute would effect a recharacterization of any investment returns that accrue on the unrealized portion of the general partner's reinvested carry. This will introduce an additional level of complexity to the already complex calculations involved in making a hedge fund's tax allocations among its partners.

By comparison, in the case of typical private equity or venture capital funds, it is unclear whether any portion of the carried interest allocation would ever qualify as return on invested capital, even if the manager does not receive current distributions of carry7 . In these funds, whether or not a manager takes current distributions of all or any part of its carried interest allocations usually has no impact on the allocation of subsequent profits earned by the fund. The profits of these types of funds typically are divided among the partners based on their actual capital contributions or capital commitments (and not based on relative capital account balances as they may vary from time to time). As a result, although any undistributed carry would constitute qualified invested capital under the Levin Bill, it is unclear that this would have any impact on the characterization of any subsequent allocations.

3. Should the manager capitulate and take its performance compensation as a fee?

Given that in most respects, even though structured as a carried interest, the fund manager will be taxed as if it had been paid a fee, managers might conclude that, if the bill is enacted, it makes sense to capitulate and use only fees (rather than carried interests) in structuring their compensation, perhaps with the goal of simplifying the fund's documentation and/or eliminating the need for clawbacks.

In this regard, it should be noted that there are still some tax advantages to structuring compensation as a partnership allocation rather than a fee. Partnership allocations can provide some tax deferral opportunities for the manager8 without being subject to the requirements and complex administrative rules imposed by Section 409A on deferred compensation and the recently enacted Section 457A rules prohibiting offshore fund fee deferrals, and without risk of the draconian penalties imposed by both of those Sections.

Furthermore, because the bill as currently drafted recharacterizes the nature of the income allocated to the general partner, but does not attempt to ignore, disallow or recharacterize the allocation as it affects other partners, structuring the performance compensation as a partnership allocation may produce more favorable tax consequences for individual limited partners, who, as discussed above, might otherwise be restricted in their ability to deduct their share of fees paid by the partnership.9

4. Can a carried interest be replaced (at least in part) with a qualified capital interest?

Some managers may want to explore the possibility of avoiding or mitigating the impact of the bill by modeling the manager's carried interest after founders' equity in a traditional start-up venture. Like the start-up entrepreneur, the manager could be seen to be contributing intangible property, such as know-how, business plans, marketing plans and computational models, in addition to future services, in exchange for both a capital account in the fund and a percentage of fund profits, thereby converting some or all (depending on the value assigned to the intangible property) of what would have been a carried interest into a "qualified capital interest," and causing that portion of the allocation to fall outside of the recharacterization provisions of the bill.10 The investors in the fund might be amenable to this arrangement, provided they had the equivalent of a distribution and liquidation preference on their capital investment in the fund, perhaps in combination with a lower overall carry percentage.

However, it should be noted that, as currently drafted, it is unclear how the bill would apply to complex arrangements with multiple classes of equity. So, the extent if any to which allocations to the manager's "junior" interest would escape recharacterization as ordinary remains at this point quite uncertain, and is unlikely to be clarified until regulations are issued.

Additionally, managers often invest substantial amounts of cash in their funds, and, in certain circumstances, fund managers may allocate a portion of their carry to attract certain seed investors who do not provide any services. When these two conditions are present, consideration should be given as to whether they can be used to cause some of the manager's carry to be treated as having been made with respect to the manager's qualified invested capital, thereby escaping recharacterization under the bill.11

5. Can options be used to compensate the manager?

Finally, in certain circumstances, where tax deferral is a goal, it may be useful to consider compensating the manager with grants of options to acquire equity interests in the fund instead of using a carried interest. Although the use of an option would not allow the manager to retain capital gain treatment on its performance compensation, assuming the strike price is at fair market value at the time the option is granted, it would allow the manager to control the timing of its income—since there would be no taxable event until exercise—without violating Section 409A (or Section 457A). However, implementing this type of arrangement can be complex in the case of hedge funds or any other funds that allow new investors to be admitted and/or capital to be contributed to and withdrawn from the fund from time to time. And, where the fund investors are U.S. taxpayers (as opposed to tax-exempt institutions or foreigners), if options are not exercised as the fund has realization events, there may be a tax cost borne by the fund's investors (resulting from the deferral of the Fund's compensation deduction until the manager exercises its option).

We will continue to follow the status of the carried interest legislation and would be happy to discuss any thoughts you may have on these matters.

If you have questions about any of the issues raised in this article, contact Charlotte Saxon at 415.399.3145 or your usual Howard Rice attorney.

1 The specific terms of a carried interest vary significantly depending, among other things, on the type of investment fund.

2 The maximum federal long term capital gain rate for individuals is currently 15% for most assets, although President Obama has proposed to allow the maximum long term capital gain rates to revert to 20% in 2011. The maximum federal income tax rate on ordinary income is currently 35%, although President Obama has proposed to allow this rate to revert to a maximum of 39% in 2011.

3 Federal employment tax rates are currently 15.3% on amounts up to $106,800, and 2.9% on amounts in excess of $106,800.

4 President Obama's proposal is not so limited, but rather appears to apply to all partnership profits interest issued for services, regardless of the nature of the services or assets.

5 Similarly, any net loss allocated to the manager on its carried interest (provided the loss does not exceed the aggregate net income that was allocated in prior years) would be allowed as ordinary. If the net loss exceeds the prior years' aggregate net income, it is disallowed and carried forward to offset income that may be allocated in future years, and if there is no subsequent income, the net loss would result in the realization of a capital loss on liquidation of the manager's interest.

6 President Obama's proposal would become effective in 2010.

7 Investors often require that, in order to secure the manager's clawback obligations, the manager must forego distributions of carry (other than distributions to pay taxes) until all investor capital has been fully returned.

8 Because the manager is not taxed on allocations of carry until there are realized gains in the portfolio.

9 If the manager is an entity with foreign or tax-exempt members, structuring the performance compensation as an allocation would also allow those members to avoid the adverse tax consequences of being allocated fee income (which constitutes "effectively connected income" and "unrelated business taxable income").

10 Of course, the IRS could contest the value of the contributed intangible property, and if successful, assess deficiencies and penalties. In this regard, it should be noted that the proposed statutory language would not (by itself) impose the bill's 40% penalty (discussed above), but the regulations that the statute instructs the Treasury to promulgate might result in the imposition of the 40% penalty if there were a successful attack on valuation in this context.

11 For example, if a seed investor invests $100x and receives one-quarter of the manager's 20% carry (that is, 5%), and if the manager invests $10x (that is, one-tenth of the seed investor's investment), then the position could be taken that, of the manager's remaining 15% carry, 0.5% (that is, one-tenth of the seed investor's 5% carry) is being made with respect to the manager's qualified capital interest, and therefore should not be recharacterized as ordinary income.

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