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President Obama's Jobs Bill Includes Revived Carried Interest Tax Increase to Ordinary Levels for Fund Managers

October 5, 2011

 

The Obama Administration has released the actual language for the American Jobs Act (the “Act”). This is the legislation the President proposed in his speech on September 8, 2011. Pursuant to the proposal, performance allocations received by a private fund manager will be taxed as ordinary income, regardless of the character of the income. This provision revives the “carried interest” legislation relating to the taxation of performance allocations passed by the House of Representatives in 2010 but never passed by the Senate.

Under the revived proposal, hedge fund and private equity fund managers have also been singled out for a special tax increase on the sale of their interests in the investment manager. The Act treats the sale of an “investment services partnership interest” as ordinary income. An “investment services partnership interest” is a partnership interest (a) in a partnership substantially all of the assets of which are securities, rental or investment real estate holdings, partnership interests, commodities, cash or cash equivalents and options and derivatives with respect to the foregoing assets (“specified assets”); (b) which is held or acquired in connection with the advising, acquiring, managing, disposing or arranging financing with respect to a specified asset, and (c) in a partnership more than half of the contributed capital of which is attributable to contributions by persons in whose hands the partnership interests constitute an investment and not a trade or business asset.

Current law treats gain derived by a manager from the sale of an interest in a partnership engaged in providing advisory services held for more than twelve months as long-term capital gain eligible for 15% federal income tax rates. This is the same treatment for the sale of an equity interest in every other business in the United States, even those that earn only ordinary income.

These new rules would be effective for taxable years ending after December 31, 2012. The tax increase applies to carried interest gain which is realized for federal income tax purposes after the effective date. Therefore, a fund manager with unrealized gains occurring prior to the effective date of the Act still will be subject to ordinary income treatment if such gains are not realized for federal income tax purposes until after the effective date of the legislation.

We will continue to monitor the progress of the Act. If the changes described above are enacted, fund managers may wish to consider certain structures to reduce some of the effects of the additional tax on the sale of interests in the manager.