On February 26, 2014, U.S. Rep. David Camp (R-MI), chairman of the House Ways and Means Committee, released a draft of the Tax Reform Act of 2014 (TRA 2014), which would provide for the most significant tax reform since the Tax Reform Act of 1986. Perhaps as a surprise to many, TRA 2014 contains new Section 1061, designed to recharacterize capital gains allocated to certain service partners (generally, investment fund managers) as ordinary income.
We have previously reported on the proposals of Congress to tax partnership income related to a carried interest as ordinary income from the performance of services, and certain proposals by New York State and New York City to subject such income to New York State tax and the New York City unincorporated business tax (see our Tax Alerts for December 31, 2007, December 23, 2008, April 18, 2012 and April 8, 2009). Proposed Section 1061 takes a very different tack from previous proposals.
Current Taxation of Income from Carried Interests
Under current law, the character of any income recognized by a fund flows through and retains its character at the partner level. Fund managers who hold carried interests are allocated their share of the capital gain recognized by the fund on its disposition of stock in a portfolio company, and would pay tax at a current rate of 20 percent on their share of the long-term capital gain. Qualified dividends (i.e., dividends from U.S. corporations, publicly traded foreign corporations and foreign corporations entitled to the benefits of a tax treaty with the United States) also are taxed at 20 percent. In addition, net investment income (including capital gains and dividend income) are subject to a 3.8 percent Medicare surcharge. It is important to note that short-term capital gains, regular dividends and interest comprising a part of the income from carried interests flows through as ordinary income, and is subject to tax in the hands of carry partners at ordinary rates of 39.6 percent, plus the 3.8 percent Medicare Surcharge.
TRA 2014 Treatment of Carried Interests
Proposed Section 1061 would recharacterize as ordinary income a portion of what would otherwise be the net capital gains to the carry partners. The portion of net capital gain potentially recharacterized is a cumulative, but non-compounded return to the carry partner equal to the long-term applicable federal rate, plus 10 percentage points. The amount of net capital gain recharacterized as ordinary income is limited to the taxpayer’s “recharacterization account balance” for such taxable year. The recharacterization account balance (which can never be negative) is equal to the current year recharacterization amounts, plus the taxpayer’s recharacterization account balance for the preceding taxable year over the sum of the taxpayer’s ordinary income with respect to Applicable Partnership Interests for the year allocable to the carry partner, plus amounts recharacterized as ordinary for the preceding taxable year. Thus, the recharacterization account balance is a cumulative amount. Stated in algebraic format, the amount recharacterized is equal to:
A x ((B xC) –D)
A = Specified Rate – the long-term applicable federal rate for the last month of the calendar year, plus 10 percentage points.
Pepper Point: If the return to carry partners is expected to exceed the applicable federal rate plus 10 percentage points, TRA 2014 should yield a better result than prior carried interest tax proposals.
B = Applicable Percentage – the highest percentage of profits of the partnership that could be allocated with respect to such interest for the taxable year, consistent with the partnership agreement and assuming such facts and circumstances with respect to the taxable year that would result in such highest percentage (e.g., hurdle will be deemed to have been exceeded each year).
Pepper Point: Thus, if the carry holder has a 20 percent carried interest and makes a 1 percent capital contribution, the Applicable Percentage would be 21 percent. Fear not, as the co-invest gets backed out later.
C = Aggregate Invested Capital – The Aggregate Investment Capital is the average daily amount of invested capital of the entire partnership for the taxable year. Invested capital means the total cumulative value, determined at the time of a contribution, of all money or other property contributed to the partnership on or before such date, reduced by the aggregate amount distributed in liquidation of partnership interests.
Pepper Point: Note that if the distribution is not in liquidation of the interest, it does not reduce Aggregate Invested Capital. Most private equity fund distributions are not in liquidation of the account. Thus, invested capital could stay artificially high.
D = Specified Capital Contribution – the average daily amount of contributed capital with respect to an Applicable Partnership Interest for any taxable year. The contributed capital is equal to the excess of the cumulative value, determined at the time of contribution, of all money or other property contributed by the partner over the total cumulative value determined at the time of distribution, of all money or other property distributed by the partnership to the partner with respect to such interest.
Pepper Point: There is a clear disparity between the way Aggregate Invested Capital and Specified Capital Contribution are determined. The reason for this disparity is not clear, but the technical discussion of the provision clarifies that this is intentional. This seems particularly unfair as Aggregate Invested Capital includes capital contributions by carry partners and Applicable Percentage seems to include allocation percentage contributable to such capital contributions.
Borrowings directly or indirectly from the partnership, any partner, or any person related to the partnership or a partner are not included as part of a partner’s Specified Capital Contributions. This is to prevent (as previous versions of carry legislation have) a taxpayer from avoiding recharacterization by borrowing money from the partnership or a partner and contributing this for his/her carried interest rather than being granted the carry outright.
Net Capital Gain, Impact of Ordinary Income and Treatment of Qualified Dividends
As described above, only net capital gains are subject to recharacterization under Proposed Section 1061; and net ordinary income reduces the recharacterization account balance, which determines the extent of any recharacterization. For this purpose, net capital gain is equal to the excess of net long-term capital gains over net short-term capital losses. Although qualified dividends are taxed at capital gain rates, they are not taken into account in determining net capital gain, and are not subject to recharacterization under this proposal.
Net ordinary income is the excess of the taxpayer’s distributive share of income and gain from an Applicable Partnership Interest over the taxpayer’s distributive share of items of deduction and loss with respect to such interests, in each case without regard to any item taken into account in determining net capital gain.
Allocations, Sales and Distributions – Acceleration of Income
Net capital gain subject to recharacterization includes gain (net of loss) allocated to the taxpayer with respect to an Applicable Partnership Interests under general partnership rules, gain (net of loss) on the disposition of Applicable Partnership Interests and gain recognized on the distribution of property with respect to an Applicable Partnership Interest. Gains on the disposition of Applicable Partnership Interests must be recognized (i.e., taken into income and, thus, subject to recharacterization as ordinary income) regardless of any exception, such as gifts. Moreover, although the distribution of property, other than cash, from a partnership generally is not a taxable event, Section 1061 would cause a partner to recognize gain equal to the excess of the fair market value over the tax basis in the hands of such partner upon receipt of a property distribution with respect to an Applicable Partnership Interest.
Applicable Partnership Interest – Who Is Covered by the Recharacterization Rules?
As with prior versions of carry legislation, proposed Section 1061 attempts to capture only certain types of service partners – generally, investment managers. An Applicable Partnership Interest is an interest in a partnership transferred to or held by a taxpayer in connection with the performance of certain services by such taxpayer or any other person (including, for example, a family member of an investment manager). The services must be performed in connection with the regular, continuous and substantial conduct of a business of:
raising or returning capital
investing in, or disposing of, trades or businesses (including research or experimentation activities)
identifying trades or businesses for investing or disposition
developing the trades or businesses described in the prior two bullets.
If a taxpayer transfers any Applicable Partnership Interest, directly or indirectly, to a related party, the taxpayer must include in income as ordinary income a proportionate amount of the recharacterization account balance. For this purpose, a related party includes certain family members, as well as any person who performed a service during the year or the preceding three years in any of the trades or business described above for which the taxpayer performed a service. This seems to get to leavers whose carry is transferred to investment managers who continue on.
No Employment Taxes
Unlike prior carried interest tax proposals, while proposed Section 1061 recharacterizes capital gain as ordinary income, it does not treat it is compensation, nor does it specifically subject the income to self-employment tax. However, this may have been viewed as unnecessary, as net investment income is subject to the 3.8 percent Medicare surcharge in any event, and, presumably, portfolio managers earning significant carry would cap out of the primary portion of SECA.
Disclosure, Regulations and Penalties
Under the proposal, a partnership must include information to the Internal Revenue Service with respect to Applicable Partnership Interests, including the amount of any partner’s annual recharacterization amount. In the case of tiered partnerships, each higher-tier partnership would be required to provide this disclosure as well.
Treasury is authorized to provide regulatory guidance on a number of matters, including those necessary to prevent abuse of the purposes of proposed Section 1061 through, among other things, special allocations or under-valuation of contributed or loaned property by non-service partners, other reductions of invested capital, treatment of tiered partnership structures and the treatment of taxpayers holding of multiple Applicable Partnership Interests.
Although a variety of existing penalty provisions potentially may apply to taxpayers who fail to correctly follow the rules described herein, unlike prior versions of carry legislation, no special penalty provisions are included in TRA 2014.
It is unclear whether sweeping tax reform is realistic at this point, though many in Congress believe it is needed. Although President Obama certainly would support legislation treating the income from carried interests as ordinary income, we understand that the President was not happy with TRA 2014, because it would decrease the top tax rates on upper income Americans. The inclusion of proposed Section 1061 shows that some support remains in Congress to change the historic treatment of carried interests. However, we have seen several drafts of carry legislation going back to 2007, and, notwithstanding the passage of other tax legislation, no version has made it through both houses of Congress. We will follow this issue closely. In the meantime, fund documentation should continue to take into account the potential for this change to occur.