Carried Interests – How About That?
By Maury Cartine, CPA and Partner, Marcum LLP, Alternative Investment Group
ORIGINALLY INTRODUCED on June 22, 2007, the carried interest proposal remained virtually unchanged for several years. The House and Senate appeared ready to zero in on fund managers for the final time with the introduction of H.R. 3970 (the Rangel Bill) on October 25, 2007. Fortunately, more pressing issues distracted the attention of our esteemed legislators. First, they were confronted with an economic collapse that rivaled anything since the Great Depression. Next, they battled through health insurance reform. Finally refocusing their sights, the House and Senate took another look at the carried interest proposal. However, the dramatic election of Scott Brown and the passing of Senator Byrd changed the dynamics that brought fund managers Christmas in June!
On May 13, 2010 four Senate Democrats and Scott Brown were reported as favoring an exemption from the carried interest legislation for venture capital firms. House member Sander Levin was reported as angrily stating there would be no carve outs for the carried interest. The White House Budget Director was quoted on May 12, 2010 as stating he expected to see carried interest pass the Senate within the next few weeks. Senator Grassley didn’t see it that way and reportedly noted that achieving 60 votes was a tall order. If the Democrats couldn’t muster 60 votes in the Senate, they feared something uniquely new to the current Congress – a filibuster!
Faced with the prospect of a filibuster, a series of amendments were proposed to mitigate the effect of the carried interest proposal on venture capital firms. On May 28, 2010, the House passed H.R. 4213 to ease the tax burden for all fund managers. Under this Bill, the amount of the carried interest taxable income treated as ordinary income and subject to self-employment tax would be limited to 50% for 2011 and 2012. Thereafter, the amount of the carried interest taxable income treated as ordinary income and subject to self-employment tax would be 75%. The concession contained in H.R. 4213 seemed like it might take the fight out of fund managers, who were preparing themselves for a carried interest that would be treated as all ordinary income and fully subject to self-employment tax under the prior proposals. The House Bill as passed would have lessened the proposed tax bite on hedge fund managers as well as private equity fund managers and real estate operators. This proposal didn’t seem to sit well with either the legislators or their primary targets, private equity fund managers and real estate operators.
On June 16, 2010, Senate Finance Committee Chairman Max Baucus proposed an amendment that would limit to fifty percent the amount of carried interest taxable income treated as ordinary income and subject to self-employment tax, but only to the extent that the carried interest income was derived from capital gains attributable to assets held more than five years. Seventy-five percent of all other taxable income attributable to the carried interest would be treated as ordinary income and subject to self-employment. Baucus had originally proposed a seven year holding period for assets subject to the 50% limit, but apparently re-thought the wisdom of that approach. After all, how many private equity fund managers hold their successful investments for more than seven years? One might argue that even five years is a very long time indeed! Further, the amended bill would generally provide no relief to hedge fund managers since they very rarely hold investments in marketable securities for more than five years. On June 24, 2010, the Senate failed to pass the amended version of H.R. 4213 by the necessary 60 vote majority (57 voting yes and 41 voting no). As a consequence, the carried interest proposal has been tabled until the fall. In the words of the famous baseball announcer, Mel Allen, HOW ABOUT THAT?
CARRIED INTEREST LEGISLATION – WHY ALL THE FUSS?
The proposed legislation would significantly change the way in which fund managers are taxed on partnership income attributable to the services they perform on behalf of the partnership.
Carried interest income (commonly referred to as the performance allocation or carve-out) for hedge fund managers, private equity fund managers and real estate operators would be re-characterized as ordinary income. Thus, fund managers would lose the benefits of the reduced tax rates (to the extent reduced tax rates continue after 2010) on qualified dividends and long-term capital gains. Finally, the ordinary income resulting from the re-characterization would also be treated as self-employment income!
The most recent proposed amendments to the proposed legislation create new challenges to the fund manager’s fiduciary responsibility. Private equity fund managers would have a personal incentive to hold an investment for five years. For example, assume the gain on the sale of a private equity investment is $50,000,000. Assuming the highest individual income tax rate rises to 39.6% (rounded to 40%) and the tax rate on long-term capital gains rises to 20%, the effect of the five year rule is illustrated below.
The fund manager receives 20% carried interest on the $50,000,000 which is $10,000,000. If the private equity investment is held for five years, the fund manager would report 50% of the gain as ordinary income and 50% as long-term capital gain. The tax on the ordinary income portion of the of the gain would be 40% of ½ of $10,000,000 or $2,000,000 and the tax on the long-term capital gain portion would be 20% of ½ of $10,000,000 or $1,000,000 for a total federal income tax of $3,000,000.
If on the other hand, the private equity investment is held for slightly less than five years (say four years and nine months), the tax on the ordinary income portion of the gain would be 40% of ¾ of $10,000,000 or $3,000,000 and the tax on the long-term capital gain portion would be 20% of ¼ of $10,000, 000 or $500,000 for a total federal income tax of $3,500,000.
Thus, by holding the private equity investment for only another three months, the fund manager would save $500,000 in income tax or 5% of his total gain.
Query: if you were the fund manager, would you be inclined to hold onto the private equity investment for another three months even though there is some risk the value of the private equity investment might decline or you might lose your purchaser? Hopefully not, but the proposed amendment does reward a fund manager who breaches his fiduciary duty to his limited partners by intentionally delaying the sale of the private equity investment for another three months. If the holding period of the private equity investment does not change the income tax result for the fund manager, he has no incentive to take any additional risk. Under current law, fund managers and their limited partners are treated equally with respect to holding periods and long-term capital gains. If the manager receives a tax benefit from holding a position for a period of more than one year, the limited partners also receive a comparable benefit. The proposed law would change this equitable result.
Furthermore, a hedge fund manager might be inclined to sell even more quickly rather than take a small additional risk by holding an investment for more than one year, since the investment manager’s tax benefit from the long-term capital gain would be diluted under the new law. Fund managers are confronted with challenges to their fiduciary duty frequently, and the overwhelming majority of fund managers carry out their fiduciary duties in exemplary fashion. Nonetheless, does it make sense for Congress to create new fiduciary challenges like the ones described above? Have we forgotten about Madoff already? Maybe the best compromise is to simply limit the amount of ordinary income to 50% from day one without regard to holding periods. This would be fairer to everyone, including the often forgotten investors. If Congress must change the long standing rules affecting the treatment of partnership income to simply raise revenue, they should do it in a way that makes the most sense.
What can we expect from Congress before and after the election in November? The best chance for a well reasoned approach to the carried interest legislation will likely occur before the election. However, members of Congress will be consumed with their own reelection efforts, and nothing may happen. After the election, there will be a number of lame-duck members of Congress who may just be angry enough to make fund managers pay dearly for their loss before they exit in January. One final thought – the proposed carried interest legislation was introduced to the House of Representatives by House Ways and Means Committee Chairman Charles B. Rangel on June 22, 2007. Since that time, the Honorable Mr. Rangel has been accused of thirteen violations of congressional ethics standards. HOW ABOUT THAT?