Hedge Fund / Private Equity Fund Alert
April 2007
Authors:
Michael W. Evans
+1.202.661.3807
michael.evans@klgates.com
William Kirk
+1.202.661.3814
william.kirk@klgates.com
Roger S. Wise
+1.202.778.9023
roger.wise@klgates.com
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please visit www.klgates.com.
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Congress Considers Changes to
Tax Treatment of Carried Interests
The recent Congressional focus on hedge funds has led some members of the taxwriting committees to consider tax changes that could affect investment funds—and their
managers—more generally. In particular, these changes could include treating “carried
interest” allocations to a fund general partner or managing member as ordinary compensation
income rather than capital gains.
Hedge fund and private equity fund general partners or managing members (referred to
below as “managers”) typically receive a fixed management fee each year based on net
assets under management or capital commitments, and a “carried interest” in the fund
entitling them to 20% of fund profits. With a domestic fund, the carried interest is typically
structured as a partnership profits interest. Under current law, this ensures that the managers
will not be taxed on receipt of the carried interest and that carried interest allocations will
retain the character of income earned by the fund. Thus, if the fund earns long-term capital
gains, carried interest allocations will be taxed at a maximum federal tax rate of 15% to
the extent these allocations are ultimately made to individuals (either directly or through
the general partner or managing member, which is itself a partnership for tax purposes).
Allocations of long-term capital gains would occur with most private equity and real estate
funds, and with some hedge funds.
Congress is apparently beginning to consider whether the tax benefits associated with profits
interests—generally deferral and conversion (i.e., treating carried interest allocations as
capital gains rather than ordinary income)—are appropriate for hedge funds and other large
private investment funds. A paper by Professor Victor Fleischer, quoted in a recent New
York Times editorial, frames the issue as whether the tax law should allow “some of the
richest workers in the country to pay tax on their labor income at a low rate.”
The focus on the taxation of carried interests flows from the general focus on hedge funds
and from the reinstatement of the “pay as you go” rules. Democrats have pledged to pass
targeted tax incentives, such as additional energy conservation and education incentives.
Under the reinstituted “pay as you go” rules, these tax cuts would need to be offset by tax
increases. Because Democrats have foresworn any broad-based tax increases, the tax staffs
are closely reviewing the tax code for proposals that would increase revenue by closing
“loopholes” or increasing compliance (such as through increased penalties). Thus, the
recent Senate version of the minimum wage bill contained a provision that would limit
deferrals of compensation (a tax benefit also utilized by offshore fund managers) to the
lesser of $1 million or the average compensation received over the five previous years.
The staff’s scrutiny of carried interests may be further encouraged by the April 2, 2007 New
York Times editorial mentioned above. Entitled “Taxing Private Equity,” the editorial notes
that the tax staffs are reviewing the issue, and urges them forward, arguing that, under the
current system, “the nation in effect waits longer for its tax revenue and gets less, as private
equity partners get more.”
No specific legislation is under consideration, and no particular approach has been determined.
The Fleischer paper, entitled “Two and Twenty: Taxing Partnership Profits In Private Equity
Funds,” discusses several possible alternatives to the current system. In addition to treating
Hedge Fund / Private Equity Fund Alert
carried interest allocations as ordinary income
regardless of the underlying character of the fund’s
income, the paper suggests eliminating deferral by
requiring realization at the time that carried interests
are received (notwithstanding valuation issues) or
imposing a cost of capital charge on managers (as
if interest on a deemed loan from the fund limited
partners or members to the managers is periodically
forgiven). It is possible that interests received by a
manager in exchange for capital contributions (i.e.,
capital interests) would be excluded from any special
treatment that applies to carried interests, although this
would obviously depend on the shape the legislation
ultimately takes.
Although the focus on carried interest taxation appears
to have been inspired by the more general focus on
hedge funds, the tax changes being considered would
affect other types of investment funds and potentially
any partnership (or entity treated as a partnership for
federal tax purposes) that issues a profits interest. It
is also not clear what collateral tax consequences
these changes might have. For example, capital gains
allocated to an individual manager generally are not
subject to self-employment tax under current law;
this might change if these allocations are treated as
ordinary income. In addition, limited partners or
members effectively receive a full deduction for
amounts allocated to the general partner or managing
member as carried interest; for many funds, the
deduction of these amounts might be subject to
limitations on “miscellaneous itemized deductions” if
the carried interest is treated as a fee.
Please let us know if you would like us to monitor
developments, to keep you apprised if the
Congressional tax committees prepare to take up
specific legislation in this area. Lawyers in our
Washington, D.C., office, including former counsels
on the Senate Finance Committee and the House
Ways and Means Committee, closely follow the work
of those committees. Please contact your K&L Gates
relationship partner or one of the authors of this alert,
whose phone numbers are listed on the front page.
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