Carried interest law is stalled but could still become effective in 2011
July 16, 2010

Many active participants in partnerships and limited liability companies (LLCs) may face significantly higher income tax burdens if the Senate agrees to legislation, which has passed the House several times in the last couple of years, that would require certain income to be taxed as ordinary income subject to self employment taxes. Currently, this income is characterized as capital gains. The legislation is directed at investment services partnership interests (ISPIs), commonly known as "carried interests" or "profit interests," and is aimed at individuals who make their living in the real estate, venture capital, and/or private equity businesses.

On May 20, 2010, Senate Finance Committee Chairman Max Baucus (D-Mont.) and Acting House Ways and Means Committee Chairman Sander Levin (D-Mich.) jointly released proposed statutory language for the American Jobs and Closing Tax Loopholes Act of 2010 ("the bill"), which included changes to the taxation of ISPIs. The bill passed by the House on May 28th. On June 8th, the Senate began debate. After more than a week of extensive debate, a few amendments, and three failed cloture votes, the Senate shelved the legislation. The Senate has given no indication as to when they will revisit the legislation and there is debate whether it will occur this year or not.

As drafted in the most recent legislation, the provisions impacting ISPIs will be effective for all taxable years beginning after December 31, 2010. If you sell an interest in an ISPI in 2011 or later the gain or loss on disposition will be subject to the new law. Further, there is no distinction for partnership interests acquired before or after the date of enactment. Consequently, a transaction resulting in a long-term capital gain being recognized in 2010 would be subject to a federal tax rate of 15%. If it is recognized in 2011 or later -- either through allocable income or the sale of the interest in the ISPI -- it could be subject to a federal rate of over 37.5 percent -- more than 150 percent higher. As a result, partners might want to determine if it is possible to recognize any built in long-term capital gains this year if they believe the law might be enacted and effective for 2011.

Possible federal rates applying to ISPIs
Although federal income tax rates could change in the future as a result of other legislation, below are the maximum income and Medicare tax rates that are currently scheduled to apply to long-term capital gains related to ISPIs in 2010 through 2013: 

Under the most recent Senate version of the bill 50 percent of income related to ISPIs will be treated as ordinary income in 2011 and 2012 and 75 percent as ordinary income starting in 2013. It is possible that property held longer than five or seven years could be subject to the 50/50 split. The maximum ordinary income and long-term capital gain rates are scheduled to increase in 2011 from 35 percent to 39.6 percent and from 15 percent to 20 percent, respectively. The ordinary income component will also be subject to Medicare taxes of 2.9 percent through 2012. After 2012, ordinary income will be subject to Medicare taxes at the rate of 3.8 percent and investment income (including capital gains), over a threshold, will also be subject to Medicare taxes at a 3.8 percent rate. The burden of Social Security taxes is not included in the percentages above.

Income related to ISPIs could come from (1) Income/gain allocated to the partner from the partnership, (2) The sale or other disposition of an ISPI, or (3) The distribution of appreciated property from the partnership.

Investment services partnership and qualified capital interests
The bill creates Section 710 of the Internal Revenue Code. Section 710 defines an ISPI as any interest in a partnership held directly or indirectly by any person, if it was reasonably expected at the time the interest was acquired that such person (or any related person) would provide, directly or indirectly, a substantial quantity of any of the following services with respect to the assets held (directly or indirectly) by the partnership:

1. Advising on, investing in, purchasing, or selling any specified asset; 
2. Managing, acquiring, or disposing of any specified asset; 
3. Arranging financing with respect to acquiring specified assets; or 
4. Any activity in support of any service described above.

However, a partner holding an ISPI can escape the higher tax rate on a qualified capital interest (QCI). Generally, a QCI is acquired upon the contribution of cash or property to the partnership in exchange for an interest that receives allocations of partnership items in the same manner as those made to partners not holding an ISPI. If the bill passes as currently written, guidance will be needed to clarify certain matters, including the situation where all partnership items are allocated to partners in the same manner and all partners provide services.

Penalties
The bill grants the IRS authority under IRC Section 6662 to double to 40 percent the penalties related to the understatement of tax attributable to avoidance of IRC Section 710.

Example
A partnership has a capital asset that could be sold for $20 million encumbered with debt of $18 million. The partnership's income tax basis in the asset is $10 million. Interests considered ISPIs own 20 percent and QCIs own 80 percent. Below are the results to the holders of the ISPIs if the asset is sold in 2010 or sold in 2013:

Back to Top

Learn more about Carried Interest Law >