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On May 28, the U.S. House of Representatives voted to delay until Jan. 1, 2011 a proposed tax increase on income related to “investment services partnership interests" (ISPIs), commonly known as "carried interests" or "profit interests." These ISPIs are often received and held by executives or principals (as additional compensation) at private equity, venture capital and real estate firms. As proposed, this tax increase on income attributable to ISPIs is substantial and, accordingly, a key element of the American Jobs and Closing Tax Loopholes Act of 2010. If enacted, income attributable to the ownership or receipt of ISPIs or subsequent dispositions of ISPIs will be: - Taxed as ordinary income at the higher ordinary income tax rates (versus the lower capital gains treatment presently afforded such income); and
- Subject to self employment taxes.
Baker Tilly Virchow Krause has previously issued a Tax Alert (prior to the new timeline) describing the proposed legislation in greater detail. If you would like to learn more on the revised carried interest law please read the Tax Alert. As the proposed legislation makes its way through U.S. legislative bodies before expected enactment, Baker Tilly Virchow Krause will continue to monitor changes and amendments to the legislation that may affect your particular tax situation. In the interim, we are pleased to provide some of the more frequently asked questions received by our tax professionals and general answers (as opposed to specific tax advice that will vary from case to case) provided in response. If you have specific questions, please contact your Baker Tilly Virchow Krause tax professional.
| Common Questions & Answers on the Revised Carried Interest Law | | Q | Is equity or stock received as a distribution from an investment partnership prior to the effective date of any applicable law considered an ISPI and thus subject to ordinary income treatment when sold or disposed of after the effective date or will the taxpayer still qualify for capital gains treatment? | | A | No. As proposed, the change from capital gains treatment to ordinary income treatment will apply only to income earned with respect to ownership or receipt of ISPIs after 12/31/10 or the sale or other disposition of an ISPI after 12/31/10; thus, transactions occurring on or before 12/31/10 will be taxed under the more favorable rates. However, note that under the proposed rules, any distribution in excess of the taxpayer’s basis will be taxed at ordinary income rates. Therefore, if a distribution occurs after the effective date, the amount distributed will be taxable as ordinary income at ordinary income rates only to the extent that the value of the distribution exceeds the taxpayer’s basis. | | Q | If the ISP has been gifted to a family partnership (FLP) or an intentionally defective grantor trust, is income received by the FLP or trust subject to the ordinary income treatment? | | A | As proposed, if the ISPI (a partnership interest in this case) is gifted before 1/1/2011, the trust or FLP, as applicable, will inherit certain tax attributes from the grantor (the person making the gift) and, accordingly, any income attributable to the ISPI prior to 1/1/2011 will retain its capital gain treatment. Any income from the ISPI earned after 1/1/2011 will be taxed as ordinary income. | | Q | Can I trigger the gain before the effective date by selling my ISPI to a third party? Are there related party issues if the sale generates a gain rather than a loss? | | A | You may sell your ISPI before the effective date and qualify for capital gain treatment in a bona fide, arms’ length transaction. Depending on the seller’s relationship to the purchaser and other transaction details, such a sale may present related party issues and limitations under I.R.C. Sections 267 and 707(b). Upon the closing of the sale of the ISPI, the purchaser will inherit certain tax attributes of the seller (the seller’s basis). | | Q | If the partnership makes a distribution in excess of my basis, is the distribution taxed at ordinary income rates or capital gain rates? | | A | The value of any distribution to the holder of an ISPI in excess of the holder’s basis in the ISPI will be treated as ordinary income. | | Q | How will this new law interact with I.R.C. Section 83(b) elections? | | A | If you have previously made or will make (on or before 12/31/10) a valid Section 83(b) election and have paid or will pay (in either case, on a timely basis) any tax (presumably at the then applicable ordinary income rates) attributable to the income recognized in connection with the election, then any income attributable to the ISPI (following a valid Section 83(b) election) may qualify for capital gains treatment provided you recognize sufficient income under the Section 83(b) election to make your interest pro-rata with all other investors. Furthermore, the facts and circumstances of every transaction and investment will vary and thus your tax professionals should review your particular transaction or investment to determine if a Section 83(b) election creates a qualified interest for your entire position. Finally, we strongly encourage you to obtain an appraisal to support the value of the ISPI received and reported in your Section 83(b) election form. | | Q | Is qualified dividend income attributable to ISPI still taxed at the lower rate? | | A | All income from an ISPI is ordinary income and thus taxable at ordinary income rates. |
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