Tax Analysts Blog

How Likely Is Carried Interest Reform?

Posted on Jun 10, 2013
During the height of the financial meltdown in 2009, Congress became obsessed with changing the tax treatment of carried interest. The idea that wealthy hedge fund managers could receive preferential capital gains treatment on their carried interest income shocked Democrats, and the media ran several stories that seemed to create public furor over the inequity. Carried interest legislation actually passed Nancy Pelosi’s House but fell apart in the Senate when Finance Committee Chair Max Baucus, D-Mont., expressed reservations. Despite practitioner fears and the IRS’s belief that legislation was imminent, carried interest reform hasn’t gotten close since. But that may finally be changing.

Carried interest is taxed under capital gains rates because of Rev. Proc. 93-27, 1993-2 C.B. 343, which states that the IRS will not tax the issuance of a profits interest. (That is a simplification of a complex issue, but a correct one.) Hamstrung by its longstanding administrative position, the Service doesn’t believe it can change the tax treatment of carried interest without new legislation. Practitioners have never been completely convinced that it would take a new law for the carried interest party to come to a close. They frequently press the IRS for reassurance that the rule won’t be changed absent a new law and they almost always get it.

Whether the IRS is right about its ability to administratively change the tax treatment of carried interest isn’t that important. It’s going to take an act of Congress. But if carried interest reform legislation couldn’t make it out of a Democratic Congress in the midst of a recession that was blamed on the financial sector, is there really any chance of it becoming law now? The answer, surprisingly, is yes.

The prospects for carried interest reform have changed. The IRS has long been delaying any administrative action in the area because it believed Congress could pass a law at any moment. While that didn’t seem likely, it was always possible. (Remember economic substance codification? No one thought that was likely to pass until it suddenly did.) Now the thinking on Capitol Hill might be shifting. The Senate Finance Committee recently released its eighth tax reform discussion paper, and changing the tax treatment of carried interest was front and center. The Finance Committee paper is important because Baucus’s opposition to carried interest reform is what killed it during the height of Democratic legislative power.

House Ways and Means Chair Dave Camp, R-Mich., has said that everything is on the table and wouldn’t deny that his tax reform plan might alter the taxation of carried interest. Carried interest can be an attractive pay-for. Some estimates say it would raise $30 billion over 10 years, which could be used to pay for sweeteners that affect a much larger bloc of the taxpaying public (like, say, homeowners, who want to keep the mortgage interest deduction off the table).

There is a lot of misinformation out there about carried interest, what it represents, and who would be hurt by taxing it at ordinary rates. The fact is that under the current legislative proposals (which would tax only a portion of carried interest compensation at ordinary rates), almost no one outside the hedge fund industry would be harmed. There wouldn’t be any less capital available for investment. There wouldn’t be a sudden withdrawal of hedge fund managers from the industry (would that really be such a bad thing for the economy?). Nothing would change but an inequitable tax policy that the IRS administratively created to benefit only a small class of very wealthy taxpayers.

Carried interest reform will almost certainly be part of any major tax reform bill offered by Camp or Baucus. But it’s also possible that even if tax reform efforts fail or stall, carried interest legislation could find its way into an extenders package or as a pay-for for deficit reduction or an extension of the debt limit. As Republican and conservative Democratic resistance has waned, the prospects for a change in carried interest rules has increased. And, frankly, it’s about time.

Read Comments (1)

Vivian DarkbloomJun 10, 2013

"Carried interest is taxed under capital gains rates because of Rev. Proc.
93-27, 1993-2 C.B. 343, which states that the IRS will not tax the issuance of
a profits interest. (That is a simplification of a complex issue, but a correct
one.) "

Well, it is a simplification, but I think you are being overly generous by
calling it a "correct one".

Rev. Proc. 93-27 provides that (except as otherwise provided in section 4.02 of
the revenue procedure), if a person receives a profits interest for the
provision of
services to or for the benefit of a partnership in a partner capacity or in
anticipation of being a partner, the Internal Revenue Service will not treat
the receipt of the interest as a taxable event for the partner or the
partnership.

If, contrary to the Rev. Proc. a "profits interest" would be taxed to the
partner or the partnership at issuance, subsequent income from the resulting
"carried interest" would still be taxed at capital gains rates (assuming that
the underlying gain is capital). "Carried Interest" is taxed at capital gains
tax rates because of the rule that the character of income derived by a
partnership and passed through to the partners retains that character in the
hands of the partner.

Now, it is true that if the profits interest would be taxed at issuance, any
income to the partner at issuance would be ordinary. The partner would then
have a cost basis in the profits interest, but any gain in excess of that basis
would still be capital (providing the underlying gain is capital).

Is strikes me that there is a close similarity here between the issuance of
this "profits interest" and the issuance of a stock option, particularly an
incentive stock option. While the valuation of a stock option at issuance is
extremely difficult (e.g. by use of Black and Scholes) the valuation focuses
only on one company. Try to value a profits interest in a partnership that
will likely make investments in many companies and many of those investments
are not currently known. How do you propose that to be done? Remember that a
"profits interest" is not a "capital interest" as such.

What most commenters fail to note (intentionally, because it doesn't fit the
meme) is that "carried interest" does not produce additional capital gain out
of thin air. Limited partners cede part of their profits interest to the
general partner in return for lower fees. This is normal arm's length give and
take. The total capital gain realized by all partners would be the same
without the carried interest rule.

The problem is the arbitrage between taxable partners and non-taxable partners
such as pension funds and endowment funds (most deals involve these parties).
It's time the folks at Tax Analysts, who really should know better, focused
their attention on the problem of tax exempts selling their tax attributes to
others. Unfortunately, that doesn't resonate as well with the general public
who want their targets to be the "usual suspects".

Apropos the latter, I do believe that private equity funds make far greater use
of carried interest arrangements than do "hedge funds".

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