Private equity fund managers, hedge fund managers and other investors utilizing strategies involving carried interest need to be mindful of the political winds. Carried interest – the practice allowing certain individuals to convert ordinary income (as well as self-employment or salary income) to long-term capital gains, qualified dividends and other distributive share items subject to preferential tax rates – has been under increased scrutiny from lawmakers on both sides of the political aisle.
Carried interest has become a vehicle for investors to participate in capital gains and other partnership income items earned through investment partnerships or in lieu of direct management fees or salaries. Examples of this type of income include qualified dividends, qualified small business stock gains or tax-exempt interest. The tax savings on carried interest can be substantial and it is seen by the Obama Administration and some members of Congress as an existing loophole that should be addressed. Support for changes regarding carried interest has also been seen from economists, investors and editorial writers within media outlets across the country. Carried interest has even been a topic in the 2016 Presidential campaign with both Donald Trump and Hillary Clinton expressing support for ending the practice.
Why Has Carried Interest Gained Political Attention?
Many of the objections to carried interest are based on the belief that allowing it to continue (as currently constituted) creates a special tax loophole or benefit for an already privileged group of people. In reality, this is generally only applicable to partnership interests awarded in return for management services, as opposed to actual investments of cash or other property by the managers. Among the proposals making the political rounds are allowing for a distinction to be made between partnership interests obtained as compensation for services and the investment of cash or property made on the same basis available to other investors.
Within the Obama Administration’s budget proposals for 2014 and 2015, the President promoted the concept of an Investment Services Partnership Interest (ISPI). Through the use of an ISPI, the income from such an interest would be taxed as ordinary income and subject to self-employment taxes. Income and gains which were demonstrably attributable to investment capital would not be so upon re-characterization, and they would be considered qualified capital interests. However, as neither budget from 2014 nor 2015 was passed by Congress, these changes were not adopted and carried interest does not appear to be a priority in the Obama Administration’s final year in office.
Congressman Dave Camp, a Republican from Michigan who has served as the Chairman of the House Ways & Means Committee, introduced the Tax Reform Act of 2014. Focused in part on carried interest, Camp’s legislation proposed a re-characterization formula to convert any capital gain from certain partnership interests held in connection with the performance of services as ordinary income. The provision would apply to a partnership that is engaged in a trade or business conducted on a regular, continuous and substantial basis.
Under the Camp proposal, a specified rate of return would be determined annually equal to the federal long-term rate plus 10 percent. The rate of return would be applied to the service partner’s share of the invested capital in the partnership. A re-characterization account balance would accumulate over time until a “realization event” takes place. When a realization event occurs, any amounts exceeding the re-characterization account balance would be eligible for capital gain treatment and, presumably, qualified dividends or IRS Section 1202 qualifying small business stock gains. While the Camp proposal earned praise from Forbes magazine for its detailed approach to tax reform, conventional political wisdom points to the fact that 2016 is an election year. The chances of Camp’s legislation or any other sort of tax reform are highly unlikely until a new Congress and new Presidential administration begin work in 2017.
The Carried Interest Fairness Act of 2015 will likely be another proposal revisited by Congress next year. The legislation was introduced in the U.S. House and Senate by Michigan Representative Sander M. Levin and Wisconsin Senator Tammy Baldwin. Levin and Baldwin are Democrats and their respective bills’ actions targeted partnership interests transferred in connection with the performance of services, as well as special rules for partners providing management services to partnerships. The legislation goes into great depth on steps that would be put into place to address many of the benefits realized through carried interests. Violations of the proposed restrictions would be subject to penalties under IRC § 6662 and the 2015 bill provides for an increase in the penalty rate to 40 percent rather than 20 percent.
The Horizon for Carried Interest is One of Change
While it is impossible to predict the future on any legislative action, especially in an election year, one possible scenario with carried interest could materialize beyond 2016 in the following manner: If, at some point in the future, Congressional Republicans choose to propose lower marginal rates of tax for corporations or for the ordinary income of individuals, the elimination of favorable tax rates on carried interests is likely to come up as a bargaining chip in the negotiations. If that occurs, it’s quite possible reforms may include significant portions of proposals that have been drafted during the past couple of years.
Alternatives to Carried Interest
Regardless of the final result that will be seen by the implementation of future tax reform acts, all indicators are pointing toward the eventuality that carried interest will be targeted for the elimination of favorable tax rates. With these potential changes looming ahead, it will become vital for investors to be vigilant regarding the actions being taken to tighten the benefits related to carried interest. As the political debate moves closer to an actual change in laws governing carried interest, investors may want to consider exit strategy options.
Depending upon the form that new tax laws and regulations ultimately take, there may be alternative approaches and strategies. Some of the options available include the following:
- Acceleration of liquidity events in the year preceding enactment, if that is knowable; elections under IRC Section 83(b)
- Holding separate and distinct interests in an entity to distinguish an investment services partnership interest from a qualified capital interest (at least to avoid uncertainty)
- Amendments to operating agreements to clarify which interests are going to generate ordinary income for investment services and which interests are bona fide capital interests
- Other steps that may be allowable depending on regulations yet to be proposed
We Can Help
The gravity of the potential changes to carried interest and the impact for investors who provide management services cannot be overstated. For private equity and hedge fund managers, the political action that could be taken on carried interest represents a new reality that could create a paradigm shift within certain investment strategies. The Elliott Davis Decosimo Investment Companies Team is experienced in the area of carried interest. We are committed to monitoring the latest trends and we can help you evaluate your use of carried interest. If you have any questions regarding carried interest, please check with your Elliott Davis Decosimo advisor or contact Tax Shareholder Karl Jordan with our Investment Companies Team.