U.S. Senate Finance Committee Chair Ron Wyden (D-Ore.) and Senator Sheldon Whitehouse (D-R.I.) on August 5, 2021, introduced legislation entitled the “Ending the Carried Interest Loophole Act” (the “Wyden Bill”).

Under the Wyden Bill, investment fund managers and others who hold carried interests in connection with the performance of services in a trade or business that involves raising or returning capital and investing in or developing certain specified assets would be required to include in income as ordinary income a “deemed compensation amount” each year. For each taxable year in which a taxpayer includes a “deemed compensation amount” in income, the taxpayer would also be treated as having realized a long-term capital loss of equal amount.

The Wyden Bill would replace Section 1061 of the U.S. Internal Revenue Code of 1986, as amended (the “Code”), which was enacted as part of the Tax Cuts and Jobs Act of 2017 and extended the long-term capital gain holding period from more than one year to more than three years with respect to certain carried interests.

Background

Alternative fund managers commonly receive two forms of revenue in exchange for services provided to a managed fund – (i) a management fee based on a percentage of commitments or assets under management, and (ii) a performance-based return calculated as a percentage of the fund’s net profits. For funds that are treated as partnerships for U.S. federal income tax purposes, the performance-based return generally is structured as a profits interest in the partnership. This profits interest commonly is referred to as a “performance allocation” (in respect of hedge funds and other funds investing primarily in marketable securities), or a “carried interest” (in respect of private equity funds and other funds investing primarily in illiquid assets). For convenience, the remainder of this discussion refers to both performance allocations and carried interests as “carried interests.”

Because a carried interest is subject to the same risk of loss as a partnership interest received by a third-party investor in exchange for a capital contribution, the net profits allocated to a fund manager in respect of its carried interest are treated as a distributive share of partnership profits. Accordingly, the character of the profits earned by the partnership (for example, long-term capital gain, short-term capital gain or ordinary income), generally flows through to the fund manager in the same manner as for other holders of partnership interests. To the extent that the fund’s profits consist of long-term capital gains (in general, gains from the disposition of capital assets having a holding period of more than one year), the favorable long-term capital gain rates would apply to the fund manager’s distributive share of such profits. As noted above, Section 1061 of the Code extended the long-term capital gain holding period to more than three years with respect to certain carried interests.

Ending the Carried Interest Loophole Act

Under the Wyden Bill, a taxpayer holding an “applicable partnership interest” (an “API partner”) would be required to recognize ordinary income equal to its “deemed compensation amount” each year, and concurrently would be treated as realizing a long-term capital loss in equivalent amount. This long-term capital loss could offset current or future long-term capital gain realized by an API partner, subject to any existing limitations on deductions or use of carryforwards. For example, individual API partners may only use up to US$3000 of their capital loss carryforwards per year as an offset against ordinary income.

Note: As currently drafted, the Wyden Bill would appear to apply to any API partner, including a C corporation.

Note: The Senate Finance Committee’s detailed summary of the proposed legislation analogizes a carried interest to an interest-free loan from the partnership to the fund manager. Within this construct, a deemed compensation amount would be the estimated forgone interest on such implicit loan from the partnership.

Note: The Senate Finance Committee’s overview of the Wyden Bill further describes the effect of the legislation as “a fund manager’s compensation income is taxed similar to wages on an employee’s W-2, subject to ordinary income rates and self-employment taxes.” The distinction between taxing carried interest in a manner “similar to wages” (for example, by requiring an ordinary income inclusion as proposed by the Wyden Bill), and treating carried interest as “compensation income,” has far-reaching consequences. Among them are (i) potential limitations on deductibility of carry borne by non-corporate investing partners, (ii) potential treatment of carried interest as “effectively connected income” by non-US carry recipients (for example, pursuant to revenue sharing arrangements between US fund managers and non-US seed partners), and (iii) potential application of deferred compensation rules under Sections 409A and 457A of the Code.

Applicable Partnership Interest

An “applicable partnership interest” generally refers to an interest in partnership profits that is held directly or indirectly by, or transferred to, a taxpayer in connection with the performance of services by the taxpayer (or a related person) in a trade or business that involves raising or returning capital and either (i) investing in or disposing of (or identifying for investing or disposition of) “specified assets,” or (ii) developing “specified assets.” The term “specified assets” generally would include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing.

Note: Similar to the current scope of Section 1061 of the Code, the breadth of this definition of “applicable partnership interest” can cause these rules to apply to a profits interest held by an employee of an affected business even when that profits interest is not in the form of a carried interest that is borne by investors in an investment fund.

Note: The term “specified assets” would apply regardless of whether a particular position is marked to market under Section 1256 of the Code.

An “applicable partnership interest” also would include (i) any applicable financial instrument or contract the value of which is determined in whole or in part by reference to the partnership (including the amount of partnership distributions, the value of partnership assets, or the results of partnership operations), as well as (ii) to the extent provided in future guidance issued by the U.S. Department of the Treasury (the “Treasury Department”), any interest in an entity other than a partnership if the interest would be an “applicable partnership interest” if the entity were a partnership. An exception would apply to non-convertible debt instruments treated as debt for federal income tax purposes.

Note: The Wyden Bill’s broadened definition of “applicable partnership interest” would target certain options and similar arrangements designed to provide the economic equivalent of a carried interest. The Treasury Department would have authority to issue regulations or other guidance that presumably could also target certain profit participating equity holdings in passive foreign investment companies that are acquired in connection with the performance of services.

Deemed Compensation Amount

A “deemed compensation amount” generally would equal the product of (i) the “specified rate” and (ii) the excess of (A) the amount equal to the “applicable percentage” of the weighted average of “invested capital” of all partners over (B) the weighted average of “invested capital” of the API partner, with invested capital being determined as of certain measurement dates. The “specified rate” would equal the par yield for five-year High Quality Market corporate bonds (currently 1.21%) for the first month of the calendar year with or within which the partnership’s tax year begins, plus nine percentage points. The “applicable percentage” would be the highest percentage of partnership profits that could be allocated to the API partner (consistent with the partnership agreement and determined as if all performance targets with respect to the applicable partnership interest had been met). The Treasury Department would be authorized to prescribe regulations for the calculation of the “applicable percentage” in cases in which the percentage of partnership profits which may be allocated to an “applicable partnership interest” under the partnership agreement may temporarily exceed the highest percentage otherwise determined.

Note: In this regard, the Senate Finance Committee’s detailed summary notes that it is not intended that a distribution waterfall “catch-up” provision that causes 100% of partnership profits to be allocated to an “applicable partnership interest” in a given taxable year should, in itself, cause the “applicable percentage” to be 100%.

“Invested capital” would be measured at least annually as of the last day of the partnership’s taxable year. Additional measurement dates would be required upon the occurrence of certain events that permit a partnership to revalue partnership property and adjust capital accounts under existing Treasury Department regulations (regardless of whether the partnership opts to do so), as well as any other date specified by future Treasury Department guidance.

Note: The Senate Finance Committee’s detailed summary provides that a partner’s “invested capital” is intended to equal the partnership’s book capital account required to be maintained under Section 704(b) of the Code and the regulations with certain modifications, including that the invested capital would be calculated without regard to untaxed gains and losses resulting from the revaluation of partnership property. Furthermore, proceeds from certain applicable loans from the partnership or any other partner (or a related person to the partnership or such other partner) would not be taken into account for purposes of determining a partner’s “invested capital.” A safe harbor would apply to a loan that is fully recourse to the borrower or fully secured by the borrower’s assets and requires payments of interest with a stated rate not less than the “specified rate.”

Accelerated Inclusion for Dispositions of Applicable Partnership Interests

The sale or other disposition of any portion of an “applicable partnership interest” would accelerate the inclusion of the “deemed compensation amount.” The amount included would equal the sum of (i) the “deemed compensation amount” as determined for the taxable year in the absence of a disposition, plus (ii) the product of (A) the amount determined in clause (i), reduced by the “deemed compensation amount” determined for such taxable year, and (B) and the number of taxable years beginning after the date of the sale or disposition and before the last day of the “applicable period.” For this purpose, the “applicable period” would be the 10-year period beginning on the date the API partner acquired the “applicable partnership interest” or, if later, the last measurement date (other than one occurring simply by reason of being a taxable year end) on which there was an increase in the API partner’s “applicable percentage” of the aggregate “invested capital” of all partners.

Reporting Obligations

A partnership would be required to report on an API partner’s Schedule K-1 for any taxable year such partner’s “deemed compensation amount,” if any, for such year. A similar reporting requirement would apply to an entity receiving a report of a “deemed compensation amount.” Any “deemed compensation amount” reported to a taxpayer by a partnership would be included in such taxpayer’s taxable income for the taxable year of the taxpayer that ends with or includes the last day of the reporting partnership’s taxable year.

Note: As currently drafted, the Wyden Bill would impose a similar reporting requirement on any entity partner (presumably including a C corporation) receiving a Schedule K-1 reporting a “deemed compensation amount.” The Senate Finance Committee’s detailed summary, on the other hand, describes this entity partner reporting requirement as applying only to partners that are partnerships or S corporations.

Amendments to Section 83 of the Code

In addition, the Wyden Bill would amend Section 83 of the Code by (i) effectively treating an election under Section 83(b) of the Code as having been made in the case of a transfer of a compensatory partnership interest, unless the recipient elects otherwise and (ii) requiring that a compensatory partnership interest be valued based on its fair market value. The fair market value for this purpose would equal the distributions a partner would receive if the partnership sold (at the time of the transfer) all of its assets for cash in a fully taxable transaction and distributed the proceeds (reduced by the applicable liabilities) to its partners in complete liquidation. An amount included in income under this provision would serve to reduce a partner’s deemed compensation amount. These amendments effectively codify the result set forth in Revenue Procedures 93-27 and 2001-43 (relating to the treatment of receipt of a partnership profits interest in exchange for the performance of services).

Regulatory Guidance

The Wyden Bill would grant the Treasury Department broad authority to issue regulations or other guidance to address abuse or otherwise carry out the proposed legislation, including its application to tiered structures, derivative interests, interests in entities other than partnerships, aggregation of assets of related partnerships, disaggregation of assets within a single partnership, and transfers of “applicable partnership interests” by gift, inheritance or other non-recognition transactions.

Effective Dates

The amendments made by the Wyden Bill generally would apply to taxable years of partners beginning after the date of enactment, with or within which ends the taxable year of the partnership beginning after such date. The amendments in respect of Section 83 of the Code, however, would apply to interests in partnerships transferred after the date of enactment.