President Obama Proposes Taxing Carried Interest as Ordinary Income

Every couple of years there are various proposals floated around congress to tax the hedge fund performance fee (or “carried interest”) as ordinary income (see a previous post on this topic from 2009 here).  This week President Obama announced a proposal to tax the “carried interest” of an investment partnership as ordinary income.  The tax will help to pay for the $447 billion American Jobs Act.  According to the White House’s section-by-section analysis of the proposed legislation, the current capital gains treatment of income from the performance of services “creates an unfair and inefficient tax preference.”

The Proposal

Because the carried interest from an investment partnership is derived from the performance of services, the proposal would tax a service partner’s carried interest as ordinary income and make it subject to self-employment tax.  The proposed language indicates that “in the case of an investment services partnership interest . . . an amount equal to the net capital gain with respect to such interest for any partnership taxable year shall be treated as ordinary income.” An investment services partnership interest is defined as “any interest in an investment partnership acquired or held by any person in connection with the conduct of a trade or business” that includes providing investment advice, managing or acquiring assets, arranging financing with respect to acquiring assets, or any activity in support of providing investment advice.

The proposal excludes any partnership interest that is attributed to invested capital (which is called “qualified capital interest” in the proposal) of a partner providing investment management services from being recharacterized as ordinary income as long as the partnership reasonably allocates its income and loss between the invested capital and any interest derived from the performance of services for the partnership.

The proposed language with respect to the carried interest can be found here under Title IV, Subtitle B – Tax Carried Interest in Investment Partnerships as Ordinary Income.

Time to Worry?

The sky is not falling yet. This proposal affects more groups than simply hedge fund managers – private equity, real estate and VC fund managers would be affected by the proposal as well.  Accordingly, there are a number of interested parties ready to challenge the bill and there is already a strong lobbying presence in Washington. In the past we've seen this issue die relatively quickly and, given we are entering another election year, it is likely that we will see it die again in committee soon.

If enacted, the proposal would be effective for taxable years beginning after December 31, 2012.

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Cole-Frieman & Mallon LLP provides legal advice to hedge funds and private equity funds.   Bart Mallon can be reached directly at 415-868-5345.