Carried Interest

Carried Interest

Posted on 19th June 2012

Written by: Corrie McConnell

Whatever happened to the proposed Carried Interest legislation?  As a real estate developer/investor, should I even care?

These are both important questions – first of all, the proposed legislation has not passed in any of the recent legislative sessions, however, it came within 3 votes of passing. Although currently it seems to be a dormant issue, it remains an option on the table in what would appear to be a near term future filled with debates over tax reform and deficit reduction. It is the possibility of future passage that more conservative tax planning will be mindful of when structuring deals involving a carried (or profits) interest in the deal structure.

As for the second question, although the public hype surrounding the proposal makes it seem as if this is a tax on hedge fund managers, the legislation as proposed has a much broader reach and directly includes the real estate development and investment industry. The proposed law would recharacterize from capital gain to ordinary income, and make subject to self-employment tax, a service partner’s share of the income of an investment partnership attributable to a carried interest because such income is derived from the performance of services. However, to the extent that a service partner contributes “invested capital” and the partnership reasonably allocates its income between such invested capital and the remaining interest, income attributable to the invested capital would not be recharacterized. Read on for an overview of what the proposed legislation is and how it affects the real estate participant.

Proposed Internal Revenue Code Section 710 provides for special tax rules for partners providing investment management services to partnerships. This situation is referred to in the proposed legislation as an “Investment Services Partnership Interest” (“ISPI”). An ISPI is:

Any interest in an “investment partnership” acquired or held by any person in connection with providing the following services with respect to the assets held by the partnership as part of the partnership’s trade or business:

A)     Advising as to the advisability of investing in, purchasing, or selling any specified asset.

B)      Managing, acquiring, or disposing of any specified asset.

C)      Arranging financing with respect to acquiring specified assets.

D)     Any activity in support of any service described in A through C above.

An “investment partnership” is one in which substantially all of the assets of the partnership are specified assets and more than half of the contributed capital of the partnership is attributable to contributions of property by one or more persons in exchange for interests in the partnership which constitute property held for the production of income.

The term “specified assets” means securities, real estate held for rental or investment, interests in partnerships, commodities, cash and cash equivalents or options or derivative contracts with respect to any of the foregoing.

Under the varying proposals for the new law, some portion or all of the income allocated to the ISPI holding partner would be taxed as ordinary income as opposed to the existing law treatment of this income being subject to capital gain tax rates. Additionally, even the income recognized upon the disposition of an ISPI would be recharacterized to ordinary income under the law.

There is an exception created in the proposed legislation from ISPI treatment – the “Qualified Capital Interest” (QCI). The QCI exception is, generally, a partnership interest that includes a partner’s capital contributions, and any income recognized by the partner under Code Section 83 upon the receipt of the partnership interest. The QCI should provide relief from ISPI treatment to service providers if the following holds true – a) allocations of items made by the partnership to the QCI are made in the same manner as such allocations are made to non-service providing QCI partners, who are not related to the partner holding the QCI and b) the allocations are significant compared to the allocations made to the QCI.   The QCI is intended to be the primary exclusion for service providing partners under the proposed new law, provided the partner recognizes income under Code Section 83 upon receipt of the interest.

One additional exception contained in some of the proposed legislation pertains to the “straight-up” deal. Partnerships with pro rata allocations based on capital contributed by partners which constitute a QCI avoid ISPI treatment as well. However, all allocations of the partnership must be pro rata. This carve out would protect the straight up deal with no carried/profits interest.

The final implication of the ISPI designation is that any income or loss from an ISPI is taken into account in determining net earnings from self employment under Code Section 1402(a). Thus any amounts treated as ordinary income under the ISPI rules described above would be treated as self employment income for the ISPI holding partner. The QCI exception would apply to the self employment aspect as well.

By now you probably realize that if the proposed carried interest legislation were to become law in its current state, it certainly would have an impact on the tax situation of the service providing real estate investor. The law would make deal structuring even more important to ensure the most tax efficient results for the partners involved. Fortunately, for the time being the issue seems to be on hold and out of the spotlight, but in an age filled with discussions of tax reform and deficit reduction, real estate professionals should be aware of the proposed Code Section 710 and its impact in case the legislation is revived in the future.

Email Corrie or connect via LinkedIN for further information!

Corrie McConnel is a tax senior manager at Dauby O’Connor & Zaleski, LLC