Client Alert: Carried Interest and Other Tax Developments


2010 has seen an extraordinary amount of tax activity and there is still significant pending tax legislation. We would like to give you a simple English broad brush overview of several significant items. If you have specific questions, we would be happy to discuss any of these items with you.

Carried Interest Legislation

Perhaps the provision of greatest concern to most clients is the proposed carried interest legislation. Procedurally, this legislation passed the House in December. In simple terms, it would force investment services partners to recognize ordinary income instead of capital gain to the extent income is allocated to such partners other than with respect to interests acquired for proportionate capital contributions. The legislation is much more complex and it contains detailed rules to frustrate taxpayer attempts to circumvent these rules as well as a 40% penalty for unsuccessful attempts. Such penalties, though, can be avoided by full disclosure, a solid tax opinion and a reasonable belief that the tax opinion was valid.

Until very recently, key senators were blocking this legislation. However, these senatorial holds have been lifted and the leadership considers carried interest legislation as a key way to pay for a politically popular tax extenders bill. The fact that this legislation is going forward to pay for other tax breaks is key to understanding the legislative process. Congress will not grandfather existing interests because that would cause a big miss on revenue targets. There is a proposed compromise whereby rates on service partner income will be higher than capital gains and lower than ordinary income rates, with the rate phasing up over time.

The Senate’s tax writers were trying to understand exactly how this legislation will work and to fine tune it to eliminate unintended consequences. This legislation applies equally to small private one off deals as well as to big funds. Any transaction with allocations that do not follow capital accounts will be open to scrutiny. In addition, other factors which Congress may deem an unacceptable work around could cause ordinary income treatment. For example, an investor or employer helping managers or employees borrow capital could taint a transaction even where all allocations are proportionate to capital contributed. As if all of this were not bad enough news for taxpayers, the administration’s budget proposes taxing all non corporate carried interests as ordinary income, not just those related to the investment services industry.

In addition to characterizing covered income as ordinary, rather than capital, the proposed legislation also would subject recipients to self employment tax, even if they were limited partners.

The universal experience of advisors to private equity and other targets of carried interest legislation is “Tell me how to beat this legislation so I can change my documents before it is too late.”   While understandable, Congress is going over board to make this legislation unbeatable and if anyone circulated a work around, the legislation would be amended to defeat it. Further, the proposed legislation gives the IRS broad regulatory authority to enforce the purpose of the legislation, taxing disproportionate income allocations to service partners as ordinary income. The combination of a 40% penalty and the broad regulatory authority grant  which can retroactively undo planning will make this an especially challenging area.

The goal of the Congressional leadership is to pass tax extenders legislation in the House before the Memorial Day recess, have a conference committee resolve House Senate issues in June, and have legislation on the President's desk before July 4.  As this memo was written, Representative Levin announced that Senator Baucus and he had reached agreement on carried interest legislation that would phase in higher rates. Details were not announced. He also indicated that the legislation would be brought directly to the floor the week of May 17, without Committee hearings. While the congressional calendar is unpredictable and timing goals often are not met, the push is on.

Economic Substance

In other developments, Congress enacted the economic substance doctrine. This doctrine, which already was judicial law in most of the country, including Pennsylvania and New Jersey, holds that a transaction will not be honored if it only has an impact on federal taxes with no other economic substance. By itself, this is not radical. What is radical are the penalties imposed for participating in a transaction that is found not to have economic substance. The law imposes a 40% penalty, unless adequate disclosure is made, in which case the penalty is “only” 20%. So, a taxpayer who has a sound legal opinion and makes full disclosure of a tax position, still faces a 20% “no fault” penalty if there is a no economic substance finding. Neither the IRS nor the courts have any discretion to waive this penalty once the finding is made.

Uncertain Tax Position Reporting

In 2006, FASB adopted FIN 48, Accounting for Uncertainty in Income Taxes. Initially it only applied to public corporations, but it has been extended to all financial statements prepared in accordance with GAAP. While partnerships do not pay taxes, their partners do. So uncertain tax positions at the partnership level become relevant. Similarly, a partnership with tax exempt investors that could be generating UBIT needs to be concerned with FIN 48. This financial standard has created a fair amount of confusion in the financial community. The IRS has now jumped into the mix. Under Congressional pressure, the IRS is proposing to require taxpayers subject to FIN 48, with over $10 million of assets, to disclose uncertain tax positions to the IRS. The disclosure would be in summary form to identify the issue and the maximum tax exposure. The IRS believes this will not add a burden since FIN 48 is already there and feels that the disclosure will allow it to better allocate audit resources. While the Congressional pressure arises from large corporations not paying federal income tax, note that $10 million of gross assets, not equity, paints with a pretty broad brush. Proposed reporting could be applicable as soon as the 2010 filing season.

Estate Tax

As you undoubtedly know, the estate tax expired this year, carryover basis returned, and in 2011 this world reverts to much lower exemptions and higher rates, but at least with carryover basis gone. A bi partisan group of representatives and senators is working on a “fix”. While details are not public, we know that the Democrats generally favor a $3.5 million exemption and a top rate of 45%, and perhaps portability of exemptions between spouses (effectively allowing a couple a $7 million exemption without resort to trusts). The Republicans are resigned to an estate tax at this point, if for no other reason than carryover basis is very unpopular and unwieldy, but they would like higher exemptions and lower rates. Any liberalization of estate tax exemptions and rates beyond making 2009 law permanent needs to be paid for under congressional paygo rules. Tax writers thus are exploring revenue raising options in this arena and taxpayers should be wary. For example, there have been proposals to terminate lack of control and lack of marketability discounts in connection with family transfers, to eliminate the attractiveness of GRATs (grantor retained annuity trusts), etc. In the past, Congress has grandfathered existing arrangements when amending estate and gift tax laws. If any reader is contemplating planning that involves transfers of non-marketable interests to family members, we urge them to act quickly.

Internal Revenue Service

At the same time the tax law somehow manages to get more complex every year in spite of bi partisan political lip service to the idea of simplification, Congress has imposed very major new burdens on the IRS. Healthcare legislation contains penalties on persons that do not carry health insurance and subsidies for certain individuals and small employers who purchase insurance. The penalties are expected to be unpopular and like all other subsidies, the potential for fraud exists. The administrative burden of these programs will be huge. The IRS has been given the task of enforcing both the penalty and subsidy programs. At this point, no one can predict the effect this will have in terms of resource diversion with respect to other matters. As Congress ramps up penalties on taxpayers and tax preparers, the expectation was articulated that these weapons would be used to prevent abuse, and not misused as a bludgeon to extract settlements in good faith areas of disagreement. But, to the extent that management is diverted by health care related tasks, there could be less supervision of field agents.

Subsidies and Benefits

At the same time that the tax vise tightens in some areas it loosens in others. For example, the tax extenders legislation continues popular bonus depreciation benefits through 2010. Congress may also be on the verge of improving various tax credits used by the real estate industry, i.e., low income housing, new markets and historic rehabilitation tax credits. There are also subsidies for hiring new workers and the list goes on. It makes more sense than ever for all businesses to examine their ability to utilize these benefits.


CIRCULAR 230 NOTICE.  Any advice expressed above as to tax matters was neither written nor intended by the sender or Klehr Harrison Harvey Branzburg LLP to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.  If this document is delivered to any person or party other than to our client to whom the advice is directed, the recipient may not and should not rely upon any advice expressed above for any purpose and should seek advice based on the recipient's particular circumstances from an independent tax advisor.

If you wish to discuss these matters further, please call Larry Arem at 215.569.4142 or Ben Kwon at 215.569.1496.