Proposed legislation that was written initially to target hedge fund managers could impact a much larger array of partnerships in areas such as real estate.

The measure, originally introduced in 2007, is aimed at "carried interest," which is the right to receive a designated share of the profits of a partnership as compensation for managing or otherwise providing services to the partnership. It is considered part of the compensation of the managers, and is in addition to any investments that they may have in the partnership.

The Tax Code currently allows the managers to pay tax on their carried interest income at the capital gains rate, rather than the individual income tax rate.

Originally authored by Rep. Sander Levin, D-Mich., a member of the House Ways and Means Committee, the proposal passed the House but was not taken up by the Senate.

It was recently rewritten and re-introduced in the current Congress as H.R. 1935, "To amend the Internal Revenue Code of 1986 to provide for the treatment of partnership interests held by partners providing services."

It has not yet been scheduled for a committee vote, but is in President Obama's budget.

"When I think of carried interest, I think back to the Diamond case [a 1974 Seventh Circuit decision affirming the Tax Court] when the issue was a payment for services," said Amy Dunbar, CPA, an accounting professor at the University of Connecticut. "Most of us believe that it is something that is taxable now and should not be delayed into the future."

"From both a revenue and a public relations viewpoint, the proposed legislation stands a good chance of passing," said Tom Ochsenschlager, vice president for taxation at the American Institute of CPAs. "The government needs the revenue, and the public associates the managers who receive carried interests with hedge funds."

"This is a basic issue of fairness," said Rep. Levin. "Fund managers are receiving compensation for managing their investors' money. They should not pay the 15 percent capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35 percent. The president's budget recognizes that this is unfair. The House of Representatives has recognized that it is unfair, and this year I hope we can act to change the law."


The bill would treat any income received from a partnership in compensation for services as ordinary income. Additionally, any income or loss treated as ordinary income or loss under this provision would be taken into account in determining net earnings from self-employment, and therefore subject to Social Security tax.

The capital gains rate would continue to apply to the extent that the managers' income represents a reasonable return on capital that they have actually invested in the partnership.

However, it could impact a broad range of taxpayers, according to tax partners at Reed Smith LLP. As currently drafted, the legislation is extremely broad in scope and generally applies, in the case of any person providing substantial advisory services, to any partnership interest issued to such a service provider by a partnership holding stock, securities, rental or investment real estate, commodities, or other specified assets.

"It goes beyond hedge funds," said James R. Tandler, a partner at the New York office of Reed Smith.

"The language is broad enough to capture arrangements beyond investment funds," echoed Angelo Ciavarella, a tax partner at the firm. "As it's currently written, it can capture a broad range of partnership arrangements, so long as they involve specified assets, and the services being provided are substantial."

Proposals to tax carried interest could slow or damage the flow of capital to real estate deals, according to NAIOP, the Commercial Real Estate Development Association. Real estate developers often accept a carried interest in a project as compensation for their involvement, making the general partner at risk for all partnership liabilities in addition to capital contributions to the partnership.

And in the case of carried interest legislation, the size of the fund doesn't matter, according to Tandler. "The legislation is not tied to the size of the partnership," he said. "The test is whether a person provides a 'substantial quantity' of a number of advisory services."

The services covered are advisory services on the acquisition or disposition of, or investment in, any specified asset; services related to managing, acquiring or disposing of any specified asset; arranging financing to acquire specified assets; and any activity in support of any of these managerial or advisory services.

"Specified assets" are defined very broadly, according to Tandler, and include most securities, rental or investment real estate, partnership interests, commodities, and options or derivatives of any of these. However, the proposed legislation does not provide guidance as to the level of managerial or advisory services necessary to constitute a substantial quantity of such services.

The updated proposal covers a broader range of transactions than the original 2007 proposal, explained Ciavarella. "It's not clear whether this was intentional, or whether they're making it so [that it's] harder to structure arrangements to avoid the provisions," he said.

"Maybe the intention is to cast a wide net and deal with any unintended consequences in regulations," suggested Tandler.

The proposed legislation does have an exception for certain qualified capital interests, allocation with respect to which generally would not be characterized as ordinary income or loss if they are made in the same manner as such allocations are made to partners not providing managerial or advisory services and the allocations made to such other partners are "significant" for this purpose, according to Ciavarella. The proposed legislation does not define "significant" for this purpose, he said.

A provision in the proposal would treat income from carried interests as "bad income" for publicly traded partnerships. Under the present law, publicly traded partnerships are taxed as corporations unless 90 percent of their income is "qualifying income," which is generally passive income in the form of rents, royalties, dividends and interest. Any income treated as ordinary income under the proposal would not be considered qualifying income, which would make it more likely that publicly traded partnerships holding investment services partnership interests would be treated as corporations for federal tax purposes, according to Tandler.

The proposal would increase the penalty for Code Section 6682 understatements related to the carried interest provisions from 20 percent to 40 percent, and would remove the reasonable-cause exception under Sec. 6664(c) of the code.

"They're very serious about this," said Ciavarella.

(c) 2009 Accounting Today and SourceMedia, Inc. All Rights Reserved.

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access