Background

Since 2007 one of the federal tax issues that the Association has followed has been the controversy over carried interest. The controversy arose when two large private equity firms, the Fortress Investment Group and the Blackstone Group decided to go public as publicly traded partnerships.

These very public IPOs brought to public and Congressional attention the longstanding practice of organizing private equity and other types of investment funds as partnerships or LLCs and compensating the general partners (or managing members) for their services in managing the enterprise via a management fee of 2% of capital plus a substantial interest in the partnership’s profits. The partnership profits interest is known as “carried interest.”

Individual investment managers provide investment advice and other services to the fund through the general partner, and may receive a profits interest in the general partner or a share of the general partner’s profits interest in the fund. Because much of a private equity fund’s profits come from holding and selling stock, income received via the profits interest often takes the form of a capital gain and is taxed at 15%.

The Blackstone and Fortress IPOs brought public and Congressional attention to the fact that some very wealthy fund managers were receiving compensation what appeared to be for services, similar to an ordinary worker’s salary, and paying tax on it at the low capital gains rate. Many policymakers think this is both unfair and bad tax policy, as they believe that all forms of compensation for services should be taxed the same.

Efforts to address the carried interest issue immediately began in Congress, and continued each yearthrough 2010. These efforts have taken the form of 1) denying partnership tax treatment to investment management firms organized as PTPs, and 2) requiring that all carried interest received by individuals for providing investment management services be taxed as ordinary income, regardless of its actual character at the partnership level. The Association has worked with a good deal of success to ensure that policymakers distinguish between the private equity firms and the more traditional PTPs that comprise its members, and that any carried interest legislation that might be passed does no harm to the latter.

The 111th Congress adjourned at the end of 2010 without having enacted the carried interest legislation. President Obama has once again included it among the revenue proposals in his budget for FY 2012. Due to the change to Republican control in the House, however, it is considered unlikely that carried interest will advance in the 112th Congress.

Carried Interest in the 111th Congress

The first development in 2009 was the inclusion of the proposal to tax all carried interest as ordinary income in President Obama’s budget for FY 2010. This was not a surprise, as he had publicly expressed for changing the treatment of carried interest.

On April 3, 2009, Rep. Sander Levin (D-MI), the author of the original carried interest bill, introduced a new version of the legislation, H.R. 1935. The thrust of the bill is similar to the versions introduced by Rep. Levin and Ways and Means Committee Chairman Rangel in the 110th Congress, taxing all income from a “investment services partnership interest” as ordinary income. Under the Levin bill, carried interest treated as ordinary income under this rule would not be considered qualifying income for a PTP–however, this version specifically states that PTP general partners which are themselves PTPs are exempted from this rule as long as substantially all their income is ordinary income or section 1231 gain (generally, income from coal or timber holdings). This language ensures that the ten GP MLPs will not be affected by the carried interest legislation. The bill provides a ten-year provision for PTPs such as Blackstone and Fortress that would be affected by the legislation.

The language exempting the GP MLPs was drafted by Association tax attorneys and provided to Rep. Levin and his staff. It can be found on page 17. This was a clear success for our lobbying efforts.

On December 9, 2009 the House of Representatives passed, by a vote of 241-181, a bill containing carried interest provisions almost identical introduced in April by Rep. Levin (see below). The Tax Extenders Act of 2009, H.R. 4213, extends a number of expiring tax provisions benefitting both businesses and individuals and uses the carried interest provisions, which raise an estimated $24.6 billion in revenue, to pay for the extensions. The language aimed at protecting the PTPs which are general partners of other PTPs was amended to eliminate the concern, raised during our Annual Meeting in June, that the language could be interpreted to require that the carried interest itself, rather than the partnership, be publicly traded.

Some technical changes in the language were still needed to ensure that traditional PTPs are not adversely affected by these provisions. These include:

We spoke extensively with the staff of the tax writing committees about these issues. On May 20, 2010 the House passed a revised version of the bill. The Senate Finance Committee released its proposed substitute for the House bill on June 8; and new Finance Committee versions were released June 16 and June 22. (New versions were released in an effort to garner the 60 votes needed to proceed to a vote on the Senate floor). With each new version, the language of the bill improved with regard to its treatment of traditional MLPs and their investors.

The June proposals were the last versions to be publicly released. In those versions, MLP operations and public unitholders are completely protected. Some MLP managers receiving IDRs would be adversely affected by the bill, however, and we continued working for the remainder of 2010 to obtain further changes in the language. The 111th Congress ended without passage of the legislation. We were told that new language had been drafted, although it never became public.

Carried Interest in the 112th and 113th Congresses

In September 2011 the President released the legislative language of his proposed American Jobs Act. The legislation included carried interest as a revenue raiser, the first time such language had been drafted by Treasury staff rather than Congressional staff.

Upon examining it, we found that the drafters at the Treasury Department had taken an approach that was different from and better than previous efforts, particularly with regard to defining “investment services partnership interest.” The Treasury language was written in a way that much more clearly targeted the investment partnerships that were supposed to have been the target of the legislation from the beginning. While previous approaches began by defining the targeted “investment services partnership interest” (ISPI) very broadly, raising the possibility of sweeping far beyond the investment community, and then at our urging added various exceptions to the general rule to make it more narrow, this approach began with a narrower, more targeted definition that required investment management to be the primary business of the partnership in question. In the opinion of our tax lawyers, this new language did not have any of the hidden traps for non-investment MLPs that we had to root out in the earlier versions.

In February 2012, Rep. Levin once again introduced carried interest legislation, “The Carried Interest Fairness Act of 2012,” H.R. 4016. The bill followed the same approach as the administration’s version: the language is identical except for an earlier effective date (date of enactment rather than 12/31/12), and some minor changes which appear to be for the purpose of cleaning up the bill language. Carried interest proposals since then have taken this form.

In the 113th Congress, Rep. Levin introduced the ‘‘Cut Unjustified Tax Loopholes Act,” H.R. 268, in February 2013. Title VI of that bill contains the carried interest provisions under the label “Ending the Carried Interest Loophole.”

For more historical background on this issue and NAPTP efforts, click here.

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