Authored by: Paul Dillon, Michelle Hobbs, and Mike Schiavo
With no clear indication how carried interest may be addressed in tax reform from the House blueprint, we’ll discuss it centered on the proposal put forward in 2010, which was the last time carried interest legislation was seriously debated. Based on the 2010 plan, many active participants in partnerships and limited liability companies (LLCs) could face significantly higher income tax burdens that would require certain income to be taxed at ordinary rates, subject to self-employment taxes. Historically, this income has been characterized and taxed as capital gains. The 2010 legislation is directed at investment services partnership interests (ISPIs), commonly known as "carried interest" or "profit interest," and is aimed at individuals who make their living in the real estate, venture capital, and/or private equity businesses.
Under the 2010 proposal, partnership income allocable to ISPIs subject to the new law in the year of enactment will be the lesser of either: (1) income for the year, or (2) income after the date of enactment. In addition, if an interest in an ISPI is sold after the date of enactment, the gain or loss on disposition would be subject to the new law. Further, there is no distinction for partnership interest acquired before or after the date of enactment. Consequently, a transaction resulting in a long-term capital gain being recognized in 2017 before enactment would be subject to a federal tax rate of 20 percent. If it is recognized after enactment -- either through allocable income or the sale of the interest in the ISPI -- it could be subject to taxation at ordinary rates, possibly ranging from 33 to 39.6 percent (39.6 percent is the current maximum federal rate). As a result, if passage of similar legislation appears imminent, partners may want to recognize any built in long-term capital gains prior to enactment of this law.
Investment services partnership and qualified capital interest
The 2010 proposal would create Section 710 of the Internal Revenue Code. Section 710 would define 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 could escape the higher tax rate on a qualified capital interest (QCI). Generally, a QCI would be 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 written (in 2010), guidance will be needed to clarify certain matters, including when all partnership items are allocated to partners in the same manner and all partners provide services.
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 $10 million. Interest considered ISPIs own 20 percent and QCIs own 80 percent. Below are the results to the holders of the ISPIs if the asset is sold before or after enactment of the new bill:
|Before enactment||After enactment|
|Proceeds to ISPI partners||$ 400,000||$ 400,000|
|Federal income taxes **||$ (400,000)||$ (660,000)|
|Net after tax proceeds/(cost)||$ --||$ (260,000)|
** Assumes a 20 percent capital gain rate and a 33 percent ordinary rate following tax reform
Most likely any carried interest provision would apply to sales and dispositions of ISPIs after the date of enactment. There may be an opportunity to lock in appreciation in an ISPI at capital gains rates if a transaction can be executed before tax reform becomes effective. Given the tax reform process is in the early stages, and what will ultimately be included is unknown, we don’t suggest any restructuring at this time. Rather, we recommend you identify such interest for possible planning, and look to see what restrictions and approvals you may need to transfer such interest, so that you have sufficient time to execute transfers if such a provision advances.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.