Taxation Of Carried Interest Under Chairman Camp’s Tax Reform Proposal

On February 25, 2014, House Ways and Means Committee Chairman Dave Camp (R-MI) issued a sweeping tax reform discussion draft, numbering almost 1,000 pages (the Discussion Draft). This alert summarizes proposals included in the Discussion Draft that affect the private investment funds industry, including the taxation of carried interest.

While it has been widely reported that the immediate possibility of Congressional action on this legislation appears low, it is possible that this legislation, or legislation based on this proposal with similar effect, could be considered and enacted in the future.

Tax Brackets and Rates

Under the Discussion Draft, the current tax brackets for individuals would be consolidated into three brackets: 10%, 25% and 35%. The 35% bracket would begin at $400,000 for single filers and $450,000 for joint filers. For high-income taxpayers, the benefit of the 10% tax bracket would phase out. Many deductions for individual expenses would be eliminated or only deductible against lower tax-bracket income.

The preferential tax rate structure for net capital gain would be repealed. Instead, noncorporate taxpayers could claim an "above the line" deduction equal to 40% of adjusted net capital gain, i.e., net capital gain plus qualified dividend income. In effect, for 35% tax-bracket taxpayers, the adjusted net capital gain would be taxed at 60% of 35%, or 21%. It also would be subject to the current "net investment income" tax of 3.8%, for a total tax rate of 24.8%.

The highest marginal corporate tax rate would be reduced from 35% to 25%, phased in from 2015 to 2019.

Carried Interest

Chairman Camp's proposal to tax certain carried interest as ordinary income differs from prior legislative proposals. This proposal can be analogized to a related-party loan, although "loan" terminology or characterization is not actually used in the Discussion Draft.

Very generally, the proposal, in effect, (i) treats a general partner as having received an interest-free "loan" from the limited partners equal to the partnership's capital that will fund the general partner's carried interest, (ii) tracks an interest-like return on this loan and, (iii) when realized, recharacterizes capital gain as ordinary income to the extent the general partner has not otherwise realized ordinary income.

Although the technical rules are quite complicated, as a general matter, if the General Partner has a 20% carried interest, it would be treated as having "borrowed" 20% of the fund's capital contributions. The interest-like amount deemed earned on this "loan" would be the amount of capital gain that is subject to recharacterization as ordinary income. The stated intent of the proposal is to approximate the portion of the general partner's earnings that the proposal's drafters view as compensation for managing the fund's capital. It is unclear, however, whether any management fee income earned by the general partner or related management company might reduce the amount of capital gain subject to ordinary income recharacterization.

When is this provision effective?

As mentioned above, although it has been widely reported that the likelihood of this particular tax reform bill being enacted appears low, it is always possible. Further, some or all of its provisions might resurface in other tax bills and be enacted in the future.

The Discussion Draft provides that this provision would be effective for taxable years beginning after December 31, 2014, with no "grandfathering" provisions for existing partnerships.

Who is covered?

The provision applies to the holder of an "applicable partnership interest" (API).

What is an API?

An API is any interest in a partnership which, directly or indirectly, is transferred to or held by the taxpayer in connection with the performance of services by the taxpayer, or any other person, in any "applicable trade or business."

Observation:

If a general partner holds both a carried interest and a capital interest resulting from a capital commitment to the fund, the capital interest does not prevent the general partner from holding an API, but it is unclear whether the capital interest (as well as the carried interest) would be treated as an API. What is an applicable trade or business?

An "applicable trade or business" is any trade or business conducted on a regular, continuous, and substantial basis which, regardless of whether the activities are conducted in one or more entities, consists (in whole or in part) of (i) raising or returning capital, (ii) investing in or disposing of trades or businesses (or identifying trades or businesses for such investing or disposition), and (iii) developing such trades or businesses.

As a result, the provision appears to...