On June 26th, the US House of Representatives approved a measure as part of H.R. 6275 that would increase the tax rate paid by investment fund managers on certain profits they receive by way of carried interests. A carried interest, sometimes referred to as a “promote interest,” is the share of profits that the manager of a private equity or other investment partnership receives as a reward for the partnership’s performance. In general, after providing the capital contributors a promised return, the manager receives a special allocation of partnership profits. Because the manager receives an allocation of partnership profits and not an additional fee, the federal government currently taxes those profits based on the character of the underlying asset generating the profits. Thus, for profits arising from the sale of a long-term capital asset, these service-rendering investment managers currently receive capital gain treatment.

Congress has focused on the taxation of carried interests since last summer, when it held multiple hearings on the issue.  Both the House and Senate heard arguments in support of and against legislation to tax profits earned by the service partners on their carried interests as compensation income. Since the conclusion of those hearings, drafts of a proposed carried interest provision – in the form of Proposed Internal Revenue Code Section 710 – have been attached as a revenue raiser to many bills. In this most recent H.R. 6275, the carried interest provision is attached as a “pay-for” to a measure seeking repeal of the Alternative Minimum Tax and extending the tax-breaks for a variety of other interest groups. This bill has since been read twice in the Senate and referred to the Committee on Finance. If enacted, Proposed Code Section 710 would be effective as of June 18, 2008.

Although the media has focused on how Proposed Code Section 710 will affect the managers of billion-dollar private equity funds, a closer look at the proposed language reveals that, if passed, this legislation would affect a much broader category of taxpayers, including those partners that do not manage “investment funds,” yet, receive a disproportionate share of partnership profits for services. Proposed Code Section 710 would treat a partner’s distributive share of income and loss attributable to any “investment services partnership interest” as ordinary income or loss. An investment services partnership interest includes any interest in a partnership held by any person, if that person provides, directly or indirectly, a substantial quantity of the following services in the conduct of a trade or business:

(a) Advising the partnership as to the value of – or advisability of investing in, purchasing or selling – any specified asset.
(b) Managing, acquiring or disposing of any specified asset.
(c) Arranging financing with respect to acquiring any specified asset.
(d) Any activity in support of the services described in (a) – (c).

Specified assets include securities (e.g., a share of corporate stock, a partnership interest, a beneficial interest in a widely-held or publicly traded partnership, bonds, notes, debentures, notional principal contracts, and interests in securities), real estate, and commodities.

Thus, if Proposed Code Section 710 becomes law, any person who chooses the best location for the partnership’s business, or decides what real estate or improvements to purchase or build, or arranges financing, or manages the ongoing business and, as a result of these efforts, receives a percentage of the partnership’s profits not reflected by a capital contribution, would be considered to hold an investment services partnership interest. Any profit earned by the service partner upon the partnership’s sale of a capital asset and any profit that is earned by the service partner upon sale of his, her, or its partnership interest, would be taxed at ordinary income rates.

Like most tax legislation, Proposed Code Section 710 raises various questions that the IRS and taxpayers will need to address to apply the statute. For instance, when – and how often – should a partnership test for investment services partnership interests? Is the characterization a permanent taint on a partner’s interest? When is a partner engaged in the trade or business of providing investment services? What constitutes a substantial quantity of investment partnership services? Each of these terms as used in the proposed legislation raises questions that Congress has yet to address but which taxpayers will be required to apply. In addition, Congress has put a premium on compliance by proposing an increase to the substantial understatement penalty from 20 percent to 40 percent for understatements related to Proposed Code Section 710 as part of this package.

The above outline provides a cursory review of the proposed legislation. If you have any questions or want further information, please contact John McCoy, Joseph A. Rieser, Robert Honigman, Robert Falb, Liz Mullen or Melanie Bartlett of Arent Fox’s tax group.

John C. McCoy
mccoy.john@arentfox.com
202.857.6175

Joseph A. Rieser
rieser.joseph@arentfox.com
202.857.8964

Robert G. Honigman
honigman.robert@arentfox.com
202.857.6041

Robert E. Falb
falb.robert@arentfox.com
202.715.8569

Elizabeth A. Mullen
mullen.elizabeth@arentfox.com
202.775.5704

Melanie L. Bartlett
bartlett.melanie@arentfox.com
202.715.8571