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Impact of Legislative Proposals to Tax Carried Interest on Alternative Asset Managers

|Includes: ALT-OLD, The Blackstone Group L.P. (BX), KKR, MCRO, MNA, OZM, PZN
Legislative Proposals Affecting Taxation of Carried Interest
Two separate bills (H.R. 1439, the “House Bill” and S. Amdt 4369, the “Senate Proposal”) containing the carried interest proposals were introduced in 2010 and both would generally treat net income from an investment services partnership interest as ordinary income for the performance of services.  Though the proposals were not enacted this year and  while it is less likely that the carried interest provision will get more traction during the remainder of the Second Session of the 111th Congress, it is likely that the 112th Congress will revisit the carried interest provision. Accordingly, fund managers and investors alike should pay close attention to the proposed legislation and should understand the impact of the proposed legislation.
Potential Impact of the House Bill and Senate Proposal
In addition to increased tax costs, the carried interest provision may also result in unduly harsh reporting requirements and increased compliance costs. For instance, just to determine whether service providing partners are exempted from the carried interest provision would substantially increase compliance costs. A service providing partner’s tax advisor will, at the minimum, have to parse through all records of historic partnership distributions, income, and losses since the service providing partners acquisition of interest, just to determine whether the partner qualifies for the exemption. 
Also, it is likely that many fund managers as well as fund investors will engage in tax-motivated restructuring of the existing structures just to avoid the tax cost of ordinary income treatment to the manager. Further, some fund managers may increase the carry percentage beyond the traditional 20 percent to defray additional compliance and tax costs. 
Reclassification of long term capital gains with respect to “tainted” partnership interest.  
Both the House Bill and the Senate Proposal seek to reclassify net income (as well as net loss) from a partnership interest (regardless of its original pass through character as capital gain or dividend income) as ordinary income (or ordinary loss) for the performance of services. Such income is currently taxed at higher ordinary income rates and is subject to self-employment tax. 
On the disposition of “tainted” partnership interests (unless such “taint” is preserved), gain (or loss) would be reclassified as ordinary income for the performance of services, despite the existing general partnership tax rule that gain or loss from the disposition of a partnership interest generally is considered as capital gain or loss (except in case of certain recaptures allocable inventory and unrealized receivables). Loss on the disposition of a “tainted” partnership interest is treated as ordinary loss, but only to the extent of the amount by which cumulative reclassified net income exceeds cumulative reclassified net losses under the provision. 

On the distribution of appreciated property by a partnership to a partner, under the current tax law, neither a partnership nor a partner recognize gain or loss on a distribution to a partner of property or money. Under the Bill and the Proposal, the partnership would recognize gain as if the partnership had sold the property at its fair market value at the time of the distribution.
Excessive Reach of the Proposal
Most tax practitioners and even the Staff of the Joint Committee on Taxation consider the reach of the carried interest provision’s reach unduly excessive and administratively burdensome. 
To illustrate the broad impact of the House Bill, consider a typical investment fund structure in which fund sponsors own interests in a management company and in a partnership having general partnership interests in an investment fund. Under the House Bill, partners’ interest in the general partnership would also be subject to the carried interest provision (though the Senate Proposal would leave the scope of the “indirect” service providers definition to the regulations).
Carve-outs for certain capital partners may prove insufficient
Partners and indirect holders of “tainted” partnership interests may still be within the scope of the carried interest provision even if they contribute capital. Generally, the House Bill and the Senate Proposal exempt from the carried interest provision service providing partners who are contributing money or other property to the capital provided to the extent of the partner’s distributive share of partnership items corresponds to the partner's invested capital (i.e., the amount of money or fair value of property contributed to the partnership). However, to the extent partnership allocations are not “straight-up” (e.g., one partner bears losses before others, management fee allocated solely to limited partners, etc.) or in case their partnership holds interests in a lower tier partnership, such capital partners may not be exempted from the carried interest provision in its current proposed form. 
In addition, a structure in which a capital partner debt financed its acquisition with a partnership guarantee (and has not repaid the debt), such partner’s capital contribution will not be counted for purposes of the exemption (to the extent of the still outstanding debt financing).

What should investors do?

Retail investors owning limited partnership interests in fund management companies should not be directly affected by the proposed carried interest legislation because in most cases they won't be considered providers of investment management services to fund advisors, so that there should be no added tax cost upon the disposition of interests. On the other hand, institutional corporate investors may be directly affected to the extent they provide custodial or other services to the fund management companies in which they hold interests, which services may be considered within the purview of the legislative proposal.

At the same time, fund management companies may incur significant additional expenses to retain their top managers, because the added tax cost of providing fund managers with equity interests may be prohibitive. Accordingly, fund management companies may need to increase the level of cash compensation, significantly increasing total employee compensation expense items and adversely affecting their overall profitability as well as distributions to retail investors.

While it is too early to scope the overall cost of the proposed legislation on the alternative asset management industry, at the minimum, the industry will be facing increased compensation, and, potentially, restructuring, costs. The market appears to have discounted some added costs alternative asset managers will face, though the market prices may further fall until the uncertainty remains.  

This note is not intended to provide any tax advice and its contents may not be used to avoid penalties under the Internal Revenue Code.  

Disclosure: None

Disclosure: None