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STORM CLOUDS ON THE HORIZON:STORM CLOUDS ON THE HORIZON:AN UNCERTAIN FUTURE FOR AN UNCERTAIN FUTURE FOR TAXATION OF CARRIED INTERESTSTAXATION OF CARRIED INTERESTS

PanelistJames Wreggelsworth

Davis Wright Tremaine LLP

James WreggelsworthPartner, Davis Wright Tremaine LLPPresented February, 2010

Circular 230

Circular 230 – To comply with IRS rules, we must inform you that these materials were not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties that may be imposed under federal tax law or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein.


What is a Carried Interest?

A carried interest (also known as a profits interest) is:

An interest in a partnership (or LLC taxed as a partnership)

Typically granted to a service provider who provides managerial or advisory services to or on behalf of the partnership

Which, on the date of grant, would not entitle the holder to any share of liquidation proceeds if the partnership’s assets were sold for fair market value, its liabilities repaid, and liquidating distributions made to its partners


Why Use Carried Interests?

Ability to avoid income recognition on receipt of a carried interest

Allows service provider to share in appreciation in partnership’s assets, generally at capital gains rates

Used routinely in real estate and operating partnerships, not just in the hedge fund context


Potential Drawbacks

Self employment tax considerations Guaranteed payments for services Share of operating profits (other than real estate rental income)

from trade or business activities

Longstanding IRS position - a partner in a partnership can’t also be treated as an employee Subjects service provider to estimated tax filing obligations Fringe benefits available for partners are less favorable than those

available for employees


Current State of the Law

Rev. Proc. 93-27, 1993-2 C.B. 343

Rev. Proc. 2001-43, 2001-2 C.B. 191

Proposed regulations under Sections 83 and 704 issued in 2003

Finalization on hold in light of pending carried interest legislation


House Passes H.R. 4213

H.R. 4213, the “Tax Extender Act of 2009,” was passed by the House of Representatives on December 9, 2009

Senate is now considering tax extenders as part of a larger jobs bill

If passed, would dramatically change the tax treatment of carried interests

Follows similar carried interest legislation proposed in the past

Included in President Obama’s FY 2010 and 2011 budget proposals


Legislative Objective

According to the House Ways and Means Committee, the bill is intended to

prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as a carried interest in an investment fund

require them to treat carried interests as ordinary income received in exchange for the performance of services to the extent that the carried interest does not reflect a reasonable return on invested capital

continue to tax carried interests at capital gains rates to the extent that the carried interest reflects a reasonable return on invested capital

Actual scope is much broader

Would fundamentally change the way most carried interests are taxed, including carried interests in real estate partnerships


Scope of Carried Interest Legislation

Applies only to an “investment services partnership interest” or “ISPI”

ISPI is broadly defined to include any interest in a partnership, if it was reasonably expected, at the time the holder acquired the interest, that

the holder or a related party would provide, directly or indirectly, a substantial quantity of “specified services” with respect to “specified assets” of the partnership



What are the specified or “tainted” services?

Providing advice regarding investing in, purchasing or selling specified assets

Managing, acquiring, or disposing of specified assets

Arranging financing with respect to acquiring specified assets

Any activity in support of the above, including supervising or assisting others who perform the services



What are the specified or “tainted” assets?

Securities

Real estate held for rental or investment

Interests in partnerships

Commodities

Options or derivative contracts with respect to securities, real estate, partnership interests or commodities

“Look-through” rule


Recharacterization Rules

Distributive share of net income with respect to an ISPI is treated as ordinary income, regardless of its character at the partnership level

Distributive share of net loss with respect to an ISPI is treated as ordinary loss, but

Allowed as a deduction only to extent of prior allocations of net income

Disallowed net loss is carried over to future years

No reduction in tax basis until the year in which the deduction is allowed



Gain realized on disposition of an ISPI must be recognized even if it would otherwise be deferred under a non-recognition provision of the Code

Gain on disposition of an ISPI will be treated as ordinary income



If a partnership distributes appreciated property to the holder of an ISPI, gain that the partnership would have recognized on sale of the asset is treated as an increased distributive share to the holder, taxable as ordinary income

Holder of the ISPI is treated as receiving a distribution of money to extent of the FMV of distributed property, resulting in gain recognition to the extent the deemed distribution of cash exceeds the holder’s tax basis in the partnership interest



An “anti-abuse” rule applies under certain circumstances where a person providing investment management services through a partnership participates in the appreciation in value of assets managed by the partnership through an entity other than the partnership.

Example: A hedge fund manager performs investment management services for the fund. The manager holds stock in a Cayman Island corporation that is a partner in the fund, and the value of the stock (or dividends) is substantially related to the assets managed by the fund. Dividends and gain on sale of the stock are recharacterized as ordinary income.


Qualified Capital Interest Exception

Distributive share of net income or loss with respect to an ISPI is not recharacterized as ordinary to the extent attributable to a “qualified capital interest”

“Piggy-back” rule applies if

Partnership items are allocated to the service provider’s capital interest in the same manner as they are allocated to the interests of unrelated non-service providers, and

Allocations made to the unrelated non-service providers are significant in comparison to the allocations made to the qualified capital interest of the service provider

IRS and Treasury to provide guidance on proper allocations if the piggy-back rule is not satisfied



What is a “qualified capital interest”?

Value of cash or property contributed to the partnership in exchange for the ISPI

Any amount included in income upon receipt of the ISPI under Section 83

The aggregate net income allocated to the ISPI for tax years to which Section 710 applies

Qualified capital interest is reduced by

Partnership distributions The aggregate net loss allocated to the holder of the ISPI for tax

years to which Section 710 applies



Special rules

An ISPI is not treated as a qualified capital interest to the extent it is acquired by the service provider with proceeds of a loan made or guaranteed by any other partner or the partnership or by a person related to another partner or the partnership

In testing significance of non-service partners’ qualified capital interests in relation to the qualified capital interest of a service provider, include amounts loaned or guaranteed by a non-service partner or a related party to the non-service partner in that partner’s qualified capital interest

Purchaser of an ISPI in a taxable transaction succeeds to the transferor’s qualified capital account.


Self-Employment Tax Considerations

All amounts recharacterized as ordinary income or ordinary loss under Section 710 are taken into consideration in determining the self-employment tax liability of the holder of the ISPI (including amounts that would otherwise be treated as gain on sale of assets)


Section 83 Considerations

Recipient of a profits interest in consideration of the performance of services is deemed to have made a Section 83(b) election unless the recipient affirmatively elects otherwise

Absent election to not have Section 83(b) election apply, recipient must take the excess, if any, of the FMV of the ISPI over its acquisition cost into income in the year in which the profits interest is issued

Liquidation value is to be used for purposes of determining the FMV of a partnership interest received in connection with the performance of services


Changes to Penalty Provisions

Boosts accurately related penalty under Section 6662 from 20% to 40% for failure to comply with recharacterization rules under new Section 710

Makes reasonable cause exception to penalty more restrictive

Requires adequate disclosure on return

Requires substantial authority for position claimed

Taxpayer must reasonably believe it is more likely than not that the position claimed is the proper treatment


Publicly Traded Partnership Rules

Income and gain recharacterized as ordinary income under new Section 710 is not considered “qualifying income” of a publicly traded partnership (“PTP”)

If more than 10% of a PTP’s gross income consists of “non-qualifying income,” the PTP will be treated as a corporation for federal income tax purposes.

Transition rule for existing PTPs

Special rule for certain partnerships owned by a publicly-traded REIT

Special rule for PTPs that own interests in exchange-traded partnerships.


Effective Dates

Recharacterization rules would be effective for taxable years ending after December 31, 2009

Transition rule for partnership’s whose taxable year straddles December 31, 2009

Changes to Section 83 rules would be effective on date of enactment

Changes to publicly traded partnership rules would be effective for taxable years beginning after December 31, 2009

Changes to penalty rules would be effective for taxable years ending after December 31, 2009


Questions, Comments?

James (Jim) WreggelsworthPartner, Davis Wright Tremaine LLP

206.757.8174 direct

206.757.7174 fax

[email protected]

Date post:	25-Jun-2015
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