The 2012 presidential campaign and the fiscal cliff debate brought our attention to many tax issues, one of which is the continuing discussion about how carried interest is taxed. Essentially, the debate of carried interest centers on whether or not investment managers and partners should continue to be afforded capital gains treatment instead of being subject to ordinary rates and self-employment taxes for their carried interest.

Since the mid-2000s, there have been several legislative and budget proposals to eliminate the favorable tax treatment of carried interest. Some of these proposals would require managing partners of investment funds to report all their income received for their services as ordinary income. Others have proposed apportioning the reportable income between ordinary and capital gains rates. Many see the debate as a tax policy issue that should not be borne by a single industry and should be done after careful consideration of the impact of these proposals.

The American Taxpayer Relief Act of 2012, as signed into law January 2, did not change the taxation of carried interest; however, it did increase the top long-term capital gains rate from 15 percent to 20 percent and the top ordinary rate from 35 percent to 39.6 percent for taxpayers over certain income thresholds. President Obama’s 2013 budget proposes that all income derived from carried interest be taxed at ordinary rates. The budget would tax a partner’s share of income from an "investment services partnership interest" as ordinary income, regardless of the partnership’s character of income. These proposals remain under negotiation; however, given the ongoing current budget and debt talks, there would seem to be a change coming to how carried interest is taxed in the future.

What Is Carried Interest?

Generally, carried interest is the share of profits that an investment fund pays to the investment manager, usually a limited partner, based on the performance of the fund. Carried interest is treated as capital gain for income-tax purposes because it is considered return on the managing partner’s investment. Each fund is different, but typically a managing partner is separately compensated with (1) a fee for managing the fund and (2) a share of the profits for creating wealth for the investors. A managing partner is taxed upon receipt of his or her share of the profits. The managing partner’s carried interest, as well as the sale of a partnership interest, is recognized as investment income, as opposed to compensation for services, and is taxed as a capital gain.

Three main types of entities subject to the existing carried interest rules are hedge funds, private equity funds and real estate ventures. To determine whether the carried interest is subject to ordinary income rates or capital gains rates, one must look to the holding period of the underlying assets. Because hedge fund investments are generally actively traded, and therefore held for a period of less than a year, fund profits are generally subject to ordinary income-tax rates. Similarly, management fees paid to a managing partner for daily operations of a real estate partnership are also taxed as ordinary income. On the other hand, private equity funds typically have a long-term operating cycle, and therefore carried interest would qualify for long-term capital gains treatment.

Benefits of Capital Gains Treatment

Supporters of the current carried interest rules justify the granting of the lower capital gains rates as a needed incentive to have individuals commit capital for investment, because it recognizes the risk taken by the manager. These proponents argue that funding for such investments may be dramatically reduced without these tax benefits, which they suggest would be bad timing for the current economic recovery.

In addition, concern goes beyond the private equity funds that were continually in the news during the presidential campaign. The real estate industry believes that investment in commercial and residential real estate ventures would be adversely affected if the current tax treatment of carried interest is changed.

These proponents predict a negative impact in employment, viability of projects and investment in much needed multidwelling residential housing. Investors rely on the carried interest tax treatment to incentivize managing partners to take on the risk of recourse debt, operational and project management and, in some cases, limited ownership.

Downsides of Capital Gains Treatment

The number of private equity and hedge funds has increased significantly over time, and fund managing partners’ compensation has increased proportionately. In some cases, funds write their agreements in such a manner that the managing partner is compensated for the creation of wealth rather than managing a fund’s daily operations, which allows the managing partner to report most or all income at the lower capital gain rates. These factors have contributed to the debate over the fairness and purpose of the carried interest rules and the impact on investments if the rules were to change.

Many opponents to the favorable tax treatment of carried interest seek to have all services provided by the managing partner classified as ordinary income with no capital gains treatment available. In making this determination, opponents do not see any difference between compensation paid to a managing partner for operating a company and those services provided by a fund’s managing partner.

Additionally, opponents see these managing partners reaping an unfair tax advantage, as it is the investor’s money that is at risk. However, some managing partners do invest a significant amount of their own capital. By applying the ordinary tax rate to all of an investment manager’s income, these opponents overlook the fact that some of the managing partner’s own money is at risk.

Impact of Changing Carried Interest Rules

Changing this favorable tax treatment would subject carried interest to federal self-employment taxes and also to federal ordinary income taxes, currently at the top rate of 39.6 percent. This change would be a huge increase in effective tax rates because of the combination of income and self-employment taxes. In addition to the federal taxes, classifying carried interest as ordinary income may make the fund managing partner liable for various state and local income taxes. In addition to affecting the managing partner’s bottom line, changes in the carried interest rules also could affect how investment funds and their managing partners structure their agreements. Attorneys should watch for further developments in the ongoing tax debate, and keep an open line of communication with investment funds and their managing partners about the potential impact of various proposals. •

Michael Sexton is a tax manager with Wouch Maloney & Co. He has more than 13 years of public accounting experience and is knowledgeable in a wide variety of tax matters. Contact him at 215-675-8364 or visit www.wm-cpa.com.