Changes to Carried Interest Taxation

Joe Albero – Tax Services

The House recently passed legislation that, if approved by the Senate, will change the tax treatment of certain partnership and LLP “carried interests,” beginning with allocations for 2011. Fund managers—including those who manage venture capital, private equity, hedge, and real estate funds—may have a portion of their carried interests taxed as ordinary income.

Current Carried Interest Treatment

When a private investment fund manager receives a share of future profits from assets under management, this compensation is known as a “carried interest.” Under current law, the character of income attributable to the carried interest (for example, whether it’s treated as ordinary income or capital gain) flows through the partnership to the carried interest holder. Because of this, carried interest is often treated as capital gain, which (for individuals) is typically taxed at lower rates than ordinary income.

Proposed Changes

Under the proposed changes, a percentage of carried interest would be treated as ordinary income, even if it otherwise would have qualified as capital gain. This change would be phased in over time, beginning with carry allocations in 2011 (carried interest taxation would remain unaffected for 2010).

For individuals, 50% of carried interests for 2011 and 2012 would be taxed as ordinary income. Beginning in 2013, 75% of carried interests would be taxed as ordinary income. For all other taxpayers, 100% of such income would be characterized as ordinary income. The bill would also apply the same percentages to self-employment tax. The remaining portion of carried interests, along with all profit from invested capital, would continue to be taxed at capital gain rates. Realized income and gains, as well as unrealized gains, on distributed assets and transfers of partnership interests are covered under the proposed changes. The Senate is expected to consider the bill within the next few weeks.

Contact Frank, Rimerman + Co. LLP

To learn how you may be affected by these proposed changes, we recommend that you seek tax advice based on your particular circumstances from an independent tax advisor. The tax advisors at Frank, Rimerman are available to assist you. For more information or if you have other questions, contact Joe Albero at [email protected].