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The recent multibillion-dollar initial public offering by the Blackstone Group, a private-equity firm, has focused attention on the tax treatment afforded private equity firms, hedge funds, and similar investment entities. Legislation has been introduced in both the Senate and House of Representatives that is intended to change the generally favorable tax treatment afforded to this segment of the investment community. The term “hedge fund” is a generic phrase designed to capture a variety of different forms of unregistered investment funds or pools of investment funds. The term “hedge fund” is most appropriately used to describe entities that engage in sophisticated securities or commodities trading (hedging) strategies but is also used in a broader context to describe other investment entities such as venture capital funds or private equity funds. For purposes of this discussion, the term “hedge fund” will be used to include all types of unregistered investment funds. Historically, hedge funds have been organized as partnerships or limited liability companies taxed as partnerships for federal income tax purposes. Although most hedge funds are commonly thought of as owned by a small group of organizers and investors, there are now several publicly traded hedge funds, such as the Blackstone Group, which have retained their partnership status. Under Code Section 7704(c), a publicly traded partnership (PTP) will avoid being taxed as a corporation if 90 percent or more of the partnership’s gross income consists of passive income, such as rent, interest and dividends, or gain from the sale of real estate and certain securities transactions. As a partnership for federal income tax purposes, a hedge fund pays no taxes at the entity level and all of its tax attributes, including both income and loss, flow-through to the owners of the hedge fund. Accordingly, the typical hedge fund structure eliminates the double taxation frequently associated with C corporations (i.e., a tax on earnings at the corporate level and a second tax at the shareholder level on dividends or other distributions). Another advantage of the flow-through nature of a hedge fund organized as a partnership or LLC is the fact that any capital gains generated by the entity will be taxed to the individual partners (or members, in the case of an LLC) at the currently favorable maximum tax rate of 15 percent. Corporations do not enjoy a special favorable tax rate for capital gains and any such gains would be taxed at the corporate level at the maximum 35 percent tax rate applicable to all other forms of corporate income. The most controversial aspect of the tax treatment of hedge funds involves the taxation of so-called “carried interests.” Such interests are generally in the form of partnership interests retained by the organizers of a hedge fund and which represent an interest in future fund profits. Although carried interests are retained by the organizers of a fund essentially to compensate the organizers for their efforts in organizing the fund and raising capital, the eventual profits realized by the organizers upon the liquidation of their carried interests is now taxed at favorable capital gains rates. A number of commentators have suggested that this capital gains treatment is inappropriate since the retained interests are compensatory in nature and should be taxed as ordinary income. The capital gains treatment afforded carried interests is founded upon tax principles contained in code sections 61 (which deals, generally, with the realization of gross income), 83 (which deals, generally, with the taxation of property received in exchange for services rendered) and 721 (which deals with the receipt of partnership interests). The interplay of all of these principles was essentially synthesized in Revenue Procedure 93-27, 1993-2 CB 343, as subsequently modified by Revenue Procedure 2001-43, 2001-2 CB 191, which confirmed that the receipt of a profits interest in a partnership in exchange for services rendered, if properly structured, is not taxable to the service provider upon receipt. On June 14, senators Max Baucus, D-Mont., and Chuck Grassley, R-Iowa, chairman and ranking Republican member of the Senate Finance Committee, introduced S.1624. If enacted into law, the Senate bill would amend Code Section 7704(c) by providing that the current exemption from treating a PTP as a corporation for federal income tax purposes for those partnerships whose income is predominantly derived from passive sources would not apply to partnerships directly or indirectly deriving income from providing investment advisory and related asset management services. If enacted, the Senate bill would effectively eliminate the attractive tax benefits currently enjoyed by any fund that, like the Blackstone Group, becomes publicly traded. As stated above, if a hedge fund is required to be taxed as a corporation, it will be subject to potential double taxation and it will not enjoy the benefits of capital gains treatment for its carried interests. Under the Senate bill, the general effective date for the amendment to Code Section 7704(c) is for taxable years beginning on or after June 14, with a five-year delayed effective date for interests which were already traded on a securities market or secondary market or which on or before such date had filed a registration statement with the SEC. In addition to the Senate bill, on June 22, 13 members of the House of Representatives, including Ways and Means Committee Chairman Charles Rangel, D-N.Y., and House Financial Services Committee Chairman Barney Frank, D-Mass., introduced H.R. 2834, which would change the characterization of income realized as a result of the ownership of a carried interest from capital gain to ordinary income. This would be accomplished by enacting new Code Section 710, which would apply to any “investment services partnership interest,” which is broadly defined to include not only carried interests in a hedge fund, but also similar interests associated with the interests retained by the organizers of a typical real estate investment trust. In addition, the House bill would also tax PTPs as corporations if they receive more than 10 percent of their income in the form of carried interests. Although the Senate bill would only attack hedge funds that elect to become PTPs, the House bill is much broader and would change the taxation of carried interests regardless of whether the carried interests were in traditional, privately owned entities or PTPs. Representatives of the hedge fund industry have argued that the current favorable tax regime is necessary for capital formation and for attracting and retaining top talent. Proponents of change argue tax fairness and equity. There is no doubt that much of the scrutiny being applied to the taxation of hedge funds results from the concern that the organizers of hedge funds have been making vast sums of money and that the public offering of interests in hedge funds is likely only to increase the amount of wealth realized by such organizers. (Steven Schwartzman, CEO of the Blackstone Group, received approximately $677 million from its IPO.) Nonetheless, there are fundamental and legitimate tax-policy issues that are raised by the ability of hedge funds to navigate through a complex and often contradictory set of tax code provisions that result in extremely favorable tax treatment. Debate on the Senate bill and the House bill will soon start and both sides on this issue have already begun intense lobbying campaigns. MARK L. SILOW is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.

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