Carried Interest Tax Legislature

By Joshua Kaplan

On Monday, September 12, 2011, the White House sent the American Jobs Act of 2011 (the "Act") to Congress. The Act includes a proposal that would require many managers of investment funds and real estate partnerships to pay tax at ordinary income rates (and pay self- employment taxes) on the "carried interest" (or promote) received from the partnership. It is uncertain whether the Act will pass in its current form, but some form of Congressional action may occur in the near future.

The legislation applies only to carried interests (or promotes) earned through an "investment services partnership interest" (an "ISPI"). An ISPI is defined as any interest in an investment partnership (generally, a partnership in which substantially all of the assets are "specified assets") held by any person that is reasonably expected to provide a substantial quantity of any of the following services with respect to the partnership's assets:

• Advising as to the advisability of investing in, purchasing or selling any "specified asset";

• Managing, acquiring, or disposing of any "specified asset";

• Arranging financing with respect to acquiring "specified assets"; and

• Engaging in any activity in support of any of the above-described services.

  A "specified asset" is defined to include certain securities, real estate held for rental or investment, interests in partnerships, commodities, cash or cash equivalents and derivatives or options on the foregoing. As a result of these broad definitions, ISPI's may, for example, include a general partner's carried interest (or promote) in typical real estate partnerships and other investment fund structures.

  Under the Act, both allocations of income made with respect to an ISPI and gain from the disposition of an ISPI are generally treated as ordinary income (subject to self-employment tax). In addition, under the Act, upon the distribution of appreciated property by a partnership to a partner holding an ISPI, the excess of the fair market value of such property over the partnership's tax basis in the property will be treated as ordinary income to the partner receiving the distribution.

  The Act does recognize that some partners holding an ISPI may also invest some of their own capital along with the other partners. As a result, the Act does not recharacterize income

allocations to, or gain from the disposition of, "qualified capital interests" ; provided that allocations to qualified capital interests of partners that also hold an ISPI are made in a similar manner (not necessarily identical) to those made to qualified capital interests held by partners that do not also hold an ISPI.

A "qualified capital interest" is generally defined to include the portion of a partner's interest in a partnership that is attributable to

• • •

the fair market value of any money or other property contributed to the partnership in exchange for such interest;

any amounts which have been included in gross income under Code section 83 with respect to the transfer of such interest; or

the excess (if any) of any items of income and gain taken into account with respect to such interest over any items of deduction or loss so taken into account.

As currently drafted, the effective date for the proposal set forth in the Act would be for taxable years ending after December 31, 2012. In light of the proposed legislation, parties may want to consider adding appropriate language to agreements governing a partnership or limited liability company to provide sufficient flexibility to restructure their arrangements in order to minimize the impact of any carried interest legislation.

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