Update on Carried Interest Legislation
There is a great deal of uncertainty among alternative investment fund managers when it comes to the future of carried interest. In the months leading up to the 2016 presidential elections, one of the few things Democratic candidate Hillary Clinton and Republican candidate Donald Trump could agree on was tax reform surrounding the favorable tax treatment of carried interest. With President-elect Donald Trump entering the White House and the Republican Party in control of Congress, the prospect of a significant tax overhaul is looming. The question is what role carried interest will play as new legislation is being formed.
In June of 2015, Senator Tammy Baldwin (Democrat – WI) and house representative Sander Levin (Democrat – MI) introduced joint legislation with the Carried Interest Fairness Act of 2015. The act deems income received by a partnership as compensation for services performed will be considered ordinary income for tax purposes. Therefore, high performing fund managers who are entitled to carried interest after generating expected returns for their Limited Partners (“LPs”) will be taxed as ordinary income rates. The maximum rate on ordinary income is currently at 39.6%, while carried interest is more commonly taxed as capital gains with a maximum rate of 23.8%. The bill also confirms that income characterized as ordinary can be treated as self-employment income. Self-employment income is subject to self-employment tax. The self-employment tax rate for 2016 is 15.3% up to $118,500 in income, 2.9% on income above $118,500 and under $200,000 ($250,000 for joint taxpayers combined) and 3.8% on amounts great than $200,000 ($250,000 for joint taxpayers combined).
This is certainly not the first time carried interest legislation has been proposed. Multiple executive budget proposals dating back to 2009 have included a plan to end the favorable tax treatment of carried interest. Congress has wrestled over carried interest for years and bills have been introduced on the House floor in 2007, 2010 and 2015.
There is a great deal of speculation on whether the Carried Interest Fairness Act will pass through the House Ways and Means committee review. One perspective is that a law like this could hinder middle market business growth by removing the incentive for investors to risk capital. The law could also have unintended consequences for small businesses and family partnerships. The law does not distinguish fund managers with institutional investors from other businesses organized as partnerships. Small and family-owned investment partnerships offering additional profits interest would no longer be able to use this as a form of compensation unless there is a revision to the Act.
President-elect Trump has been quoted on numerous occasions claiming he would end the “carried interest loophole”. This is just one of the many tax policy changes discussed on the campaign trail. President-elect Trump and the Republican Party could incorporate the taxation of carried interest at ordinary rates as a revenue driver and bargaining chip for a tax overhaul in the coming year. With the primary objective being lower individual and business income tax rates, carried interest could play a role in finding common ground for opposing parties.
For additional information relating to the Carried Interest Fairness Act of 2015, please see the following article: Investment Companies Advisor: Lawmakers Continue to Take Aim at Carried Interest
Management Fee Waivers
Private fund managers receive a portion of their compensation in the form of a fixed periodic fee more commonly called a management fee. Many fund managers have adopted a common industry practice of waiving this fee in exchange for additional future fund profits. By relinquishing these fixed fees taxed at ordinary rates, fund managers have the opportunity to receive fund profits, potentially taxed at more advantageous rates. The Internal Revenue Service now intends to limit the arrangements that qualify for this favorable tax treatment.
On July 23, 2015, the Treasury Department and IRS published proposed Treasury Regulation Section 1.707-2 providing guidance to partnerships and their partners on arrangements that will be considered a disguised payment for a service. Dating back to 1984, the Treasury has had authority to issue regulations that deem a partnership allocation in exchange for services performed as a transaction between the partnership and a non-partner. Subsequently, that payment will be taxed as ordinary income. The proposed regulations provide six factors and six examples that would be used to determine whether a fee waiver arrangement is in fact a disguised payment for services.
The primary factor to consider is entrepreneurial risk. In other words, the IRS will be comparing the amount of risk borne by the service provider in comparison to the amount of entrepreneurial risk borne by the investment fund. If the assessment is not comparable, that could be an indication that the fund is indeed receiving compensation for providing a service. The following factors and circumstances would be used in assessing if the payment was in fact subject to entrepreneurial risk:
- A cap in the amount of income to be allocated under the fee waiver agreement
- An allocation when the service provider share of income is reasonably certain
- Allocations of gross income items versus net income
- An allocation that is fixed and determinable to ensure sufficient profits
- Non-binding or untimely waivers
The IRS will also be looking at the following five factors in addition to entrepreneurial risk:
- The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration.
- The service provider receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment.
- The service provider became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third party capacity.
- The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution.
- The arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by persons that are related under IRC Sections 707(b) or 267(b) and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
Although the proposed regulations are primarily focused on management fee waivers, language in the regulations could impact other areas of the private equity compensation model. Most waterfall models include catch-up allocations. These allocations are usually up to a fixed amount. This also happens to be one of the factors considered when assessing entrepreneurial risk. Fortunately, the IRS addressed this point in the preamble comments:
“By contrast, certain priority allocations that are intended to equalize a service provider’s return with priority allocations already allocated to investing partners over the life of the partnership (commonly known as ’catch-up allocations’) typically will not fall within the types of allocations covered by the fourth example and will not lack significant entrepreneurial risk, although all of the facts and circumstances are considered in making that determination.”
The IRS is taking this stance mainly because the catch-up allocation is contingent on the appreciation of partnership assets, which in most cases is not reasonably certain, therefore the service provider does not lack entrepreneurial risk.
Another area to consider as it relates to the proposed regulations is the application of Revenue Procedure 93-27. Under 93-27, a receipt of a partnership profits interest for services is not a taxable event. There are three exceptions to this rule, however, and the preamble to the proposed regulations is adding a fourth: “The additional exception will apply to a profits interest issued in conjunction with a partner forgoing payment of an amount that is substantially fixed (including a substantially fixed amount determined by formula, such as a fee based on a percentage of partner capital commitments) for the performance of services.” In addition to the updated revenue procedure, the preamble also confirms that Rev. Proc. 93-27 does not apply to transactions where one party (e.g. Management Co.) provides services and another party (e.g. GP) receives a seemingly associated allocation and distribution of partnership income or gain. It appears that the Treasury intends to disallow the tax-free receipt of partnership profits interest for management fee waivers, irrespective of the fee waiver being deemed a disguised payment for service.
The IRS held a hearing on February 26, 2016, to solicit public comments. They stated the final regulations would be issued in the coming months. The regulations will apply to any arrangement entered into or modified after the publication of the final regulations. This would also include arrangements entered into before the final regulations are published if the fee is waived after the publication of the final regulations. Furthermore, the IRS states that the proposed regulations reflect congressional intent. Agreements made before the final regulations are published will be subject to historical legislation provisions. In other words, the Internal Revenue Code citations already in existence that provide the foundation of the proposed regulations can be used to determine if an arrangement is a disguised payment for services.
There are certain steps fund managers need to be taking now in order to prepare for the final publication of the proposed regulations. First they need to review their existing waiver agreements and assess if they are written in accord with the proposed regulations. If the current agreements violate one of the key factors listed in the proposed guidance, managers should consider amending their agreements or opting out of their current program entirely.
IRS Audit Trends
The Internal Revenue Service has been dealing with a number of changes in recent years. Their funding has dropped $900 million between 2010 and 2015. The total number of IRS personnel, including key enforcement positions has dropped 24 percent over the same time span. While the IRS is looking to do more with less, they also have to adapt to trends in the business community. There has been a major shift in the number of businesses organized as partnerships. The number of partnerships has increased 61 percent from 2002 to 2015. Additionally, the Government Accountability Office reported that the number of large partnerships (i.e. more than $100M in assets and more than 100 partners) increased 200 percent from 2002 to 2011. Exacerbating the matter further, the Treasury Inspector General for Tax Administration found the IRS has no effective way to assess the productivity of its partnership audits.
Despite continuously declining resources the IRS is developing strategies and methods to maintain key enforcement statistics. In response to the increase of partnerships being formed and partnership tax returns being filed, the IRS has begun to focus on pass-through audits and shift its focus away from corporate entity audits. The Fiscal Year 2015 Enforcement and Service Results reveal some interesting facts:
- The Audit Coverage rate for Partnerships has increased more than 18 percent from FY14 to FY15.
- Large C corporations (assets $10 million and higher) are being audited at the lowest percentage in 10 years—down to 11.15 percent of returns examined in fiscal year 2015, a decrease of 8.83 percent from 2014 when 12.23 percent of returns were audited.
- Total Enforcement Revenue collected has decreased only five percent from FY14 to FY15.
- FY15 total Enforcement Revenue collected has increased when compared to FY13 and FY12.
We should expect this trend to increase with the passing of the Bipartisan Budget Act of 2015. This act includes streamlined entity-level audit rules for certain partnerships. Starting in 2018, the partners of the partnership may no longer be assessed and notified of adjustments relating to their ownership of the partnership. The partnership entity could be liable for any underpayment and penalties resulting from an audit adjustment directly. These requirements are complex and contain options for some partnerships to opt out of the rules or shift the tax burden back to the partners.
For additional information relating to the new partnership audit rules, please see the following article: New Partnership Audit Rules – How Will Hedge Funds and Private Equity Funds be Affected?
Tax Structuring Trends
Traditionally, private equity funds will implement corporate “blockers” when investing in pass-through entities (i.e. partnerships, LLCs). This is to protect tax-exempt and foreign investors that are sensitive to unrelated business taxable income (“UBTI”) and effectively connected income (“ECI”). As a distinct investor, the blocker reports the income from the pass-through investment and pays tax on that income. Therefore, the UBTI and ECI income is no longer allocated to the respective investors.
There has been a shift in this practice and investors are opening up to the idea of pass-through structures with the absence of a blocker. Although this leaves tax-exempt and foreign investors vulnerable to additional tax filings and income tax obligations, there are a number of economic benefits to the fund manager that improve the performance of the fund as a whole. When the fund holds an investment through a subsidiary blocker, that blocker is subject to an income tax liability on earnings from the investment and gain proceeds when the investment is sold. The investors in the fund will be subject to a second level of tax on distributed earnings from the blocker to the fund. By eliminating the blocker, the fund is no longer subject to two levels of taxation and the deal exit is more tax efficient.
An additional benefit to investing directly in a partnership or pass-through structure is the purchaser will receive a step up in basis making the deal more attractive in the market place. In order for the buyer to achieve this favorable treatment when purchasing a partnership interest, the buyer must have an IRC Section 754 election in place or have the ability to make the election. This type of structure also offers additional flexibility in terms of mergers and restructurings. In turn, deal flow improves and there is potential for a higher sales price.
Implementing the flow-through structure has administrative implications that fund managers need to consider as well. There is potential for a delay in delivering Schedules K-1 to your LPs because tax information from the pass-through investment is not timely received. Furthermore, LPs may be subject to mandatory state income tax filings and withholding in jurisdictions where the lower-tier entity operates. Fund managers should analyze these factors among others when determining the most effective structure for their deals.