Under existing law, no tax is imposed on the receipt of a partnership interest unless the receiving partner obtains an interest in the partnership that includes a share in the value of its assets as well as its income from operations. Then, when partnership assets are sold, the income is taxed to such partners as capital gain at a rate that does not exceed 20 percent under existing law rather than the higher rates imposed on income from services that can reach 39.6 percent. This has enabled smart tax lawyers to structure partnerships that enable all of the partners, including the managers, to acquire, own, operate and sell assets the income from which is taxed at the more favorable rates imposed on long term capital gains. Thus the managers of these partnerships are enabled to enjoy the lower rates imposed on the gain from the sale of partnership assets although, in the main, their share of the sale proceeds represents compensation for organizing and managing the business.
This has enabled the development of a tiered partnership structure for private equity firms that acquire controlling interests in companies with the objective of arranging financing and providing management skills that will enable the companies to grow sufficiently over a period of five to seven years that they can be sold at a substantial gain that is taxed to both the managing members and investors of the firm as capital gain. Some of the managing members of the most successful of these firms have become billionaires while being taxed on most of their income at the rate imposed on capital gains.
The current administration and many in the Congress consider this tax strategy to be an abuse, although completely legal under existing law. As a result, it has also been targeted in Congress in past years and is again targeted in proposed legislation for the current session. The legislation would tax the share of gain from the sale of partnership assets paid to managing members of partnerships structured as described above as ordinary income.
Although promoted as an effort to ensure that billionaires pay their fair share of taxes, the proposed legislation would also affect the manner in which many real estate development projects, including relatively small projects, have been structured that has enabled developers to obtain the cash equity needed to undertake and complete their projects. There is little doubt that the favorable after tax outcome for the sponsors of developments structured in this manner has encouraged many ambitious and talented individuals to undertake projects that otherwise might never have been built.
Here is how the proposed carried interest legislation works. Any partnership that holds “specified assets,” which include “real estate held for rental or investment, and interests in such partnerships” would be taxed as an “investment partnership.” Gain from the sale of the assets of an investment partnership, from the distribution of assets to its members or from the sale of the partnership business or an interest in the partnership would be taxed to its managers on their share of the gain as ordinary income. As implied above, this legislation would affect all partnerships regardless of their size or the amount of the gain. Also, the legislation would not be applied prospectively. It would apply to any partnership that satisfies the foregoing definition no matter when it was formed or how long it has owned its assets. Often, real estate projects are designed to be held for many years before they are sold, hopefully at a substantial gain. If sold by an investment partnership, the gain accumulated over the entire period that the property has been held would be lumped into the year of the sale and taxed to the managers as ordinary income.
While there is a reasonable basis for the claim that the most of the compensation derived by the managers of investment partnerships is based on the services they provide and for that reason may seem unduly generous to them, it is also true that most service providers are taxed annually for their services. This includes individuals such as real estate brokers and others who are compensated by commissions or in the form of bonuses to whom the managers of investment partnerships have been compared by the sponsors of the legislation. As described, that is not true for managers of investment partnerships. There is little doubt that, if passed, the carried interest proposal will have a negative effect on real estate development.
Until now, the House of Representatives has steadfastly refused to consider any of the carried interest proposals presented to it. However, the current tax reform proposal presented to the House for consideration by David Camp, the chairman of its Ways and Means Committee, includes a carried interest provision that may have an increased likelihood of success. Developers and their tax advisors will have to take this into account in structuring future real estate development projects.
In addition to the proposed legislation, there is another possible cloud over carried interest. Recently, the First Circuit Court of Appeals in Boston held that under ERISA, the law governing company pensions, a private equity fund was engaged in a trade or business and therefore responsible for the unfunded balance in the pension fund of a bankrupt company in which it owned a controlling interest. There are those who believe the rationale of the decision might be applied to change the treatment accorded to managers of investment partnerships under the tax laws as well. To date, the Internal Revenue Service has not seemed eager to take adopt this position that would have broader application than the proposed legislation.
This will update a comment posted on this site regarding legislation proposed by the administration that would change the manner in which so called carried interest is taxed. The comment described the potentially adverse effects of this proposal on real estate development projects. As observed in the comment, the real impetus for the legislation is disapproval of the very substantial tax benefit enjoyed by members of private equity firms organized to acquire, improve and sell businesses. The recently proposed tax reform legislation submitted to the House of Representatives by Representative David Camp, the Chairman of the Ways and Means Committee, includes a provision that would tax gain allocated to managers of private equity firms as ordinary income but would not change the manner in which gain allocated to the managers of real estate development entities is presently taxed. Your author believes that, if carried interest legislation is approved, the Camp proposal is more likely to be the provision adopted. The administration proposal is aimed primarily at highly compensated individuals engaged in finance. Therefore, those who favor that legislation may be more willing to compromise than the majority in the House that to date has been firmly opposed to any change in the manner in which carried interest is taxed.
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