Thursday, November 09, 2017

House tax reform: a closer look at carried interest and RSUs

By Mark S. Nelson, J.D.

House Ways and Means Committee Chairman Kevin Brady (R-Texas) offered a second set of amendments that deal directly with carried interest and restricted stock units. Chairman Brady had already introduced a substitute bill that made numerous conforming amendments to the original tax reform bill and removed a proposed limit on the exemption for income under treaty. The next step is for the committee to wrap up its days-long markup session and vote on whether to advance the reform package to the full House.

The Brady amendment (summary) would make numerous changes to the original tax reform bill text. Overall, the amendments will hearten some who fought for changes to the tax reform bill’s treatment of employee shareholders and songwriters, but may rankle others because of newly proposed anti-fraud measures related to the earned income tax credit and a five-year sunset for persons eligible for the dependent care assistance exclusion. The Brady amendment was adopted by a vote of 24-16. The Senate is expected to publish its tax reform bill soon and Sen. Tammy Baldwin (D-Wis) has already urged senators to include her bill on carried interest in the Senate’s tax reform package.

Carried interest. The House tax reform package initially did not include provisions for closing the carried interest loophole. The Brady amendment would lengthen the current one-year holding period for some partnership interests to three years in the case of certain applicable partnership interests. The Treasury Secretary could provide that the longer holding period would be inapplicable to assets not held for investment on behalf of others. The amendments to the Internal Revenue Code would be effective for taxable years after December 31, 2017.

Under the amendment, “Applicable partnership interest” would be defined as “any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.” But the definition would not apply to certain interests held by those employed by entities that only provide services to other entities. The definition also would be subject to exceptions for: (1) partnership interests held by a corporation; or (2) capital interests in a partnership entitling a taxpayer to a share of the partnership’s capital based on either capital contributions or the value of the interest under Code Section 83.

“Applicable trade or business” would mean a regularly-conducted activity that includes raising or returning capital and either investing in (or disposing of) or developing specified assets. “Specified assets” includes securities, commodities, and derivative contracts.

Representative Sander Levin (D-Mich) attempted to clarify the impact of the Brady amendment on carried interest in an exchange with the committee’s sole witness, Thomas Barthold, chief of staff for the Joint Committee on Taxation (JCT), a nonpartisan committee of the U.S. Congress. Representative Levin first asked what impact the longer holding period would have. Barthold said that sales of partnership interests within the three-year period would be treated as short-term sales and, thus, subject to ordinary income tax rates. As a result, Bathold said the amendment should be a revenue raiser.

Representative Levin then asked Barthold for the impact of the remainder of the carried interest amendment, specifically whether more or fewer entities would be subject to limits as compared to Rep. Levin’s bill on closing the carried interest loophole. Barthold replied by describing the outlines of the carried interest amendment, including its application to specified assets. When pressed by Rep. Levin, Barthold conceded that he had not yet completed a quantitative analysis of the amendment, but he said the amendment was likely narrower than Rep. Levin’s bill.

As a candidate, President Trump had proposed closing the carried interest loophole, but as president, his views on carried interest have been less clear, although he has more recently suggested the loophole could be eliminated. When the Trump Administration previously announced its intention to pursue a major tax reform bill, Gary Cohn, President Trump’s chief economic advisor and director of the National Economic Council, issued a brief statement outlining the scope of tax reform without mentioning carried interest. Democratic lawmakers then introduced mirror image bills in the House and Senate that would close the carried interest loophole.

The Carried Interest Fairness Act of 2017, sponsored in the Senate by Sen. Baldwin (S. 1020), and in the House by Rep. Sander Levin (D-Mich) (H.R. 2295), would treat income earned from managing hedge funds and private equity funds as ordinary income instead of long-term capital gains, according to an FAQ issued with the announcement that the legislation would be re-introduced in 115th Congress. Senator Baldwin and Rep. Levin emphasize that their bill would raise $15.6 billion over 10 years, based on an estimate by the JCT.

Specifically, the Carried Interest Fairness Act would apply to “investment services partnership interests” that are acquired or held by a person in connection with the conduct of certain trades or businesses, including ones that primarily involve: (1) advising about investments in a specified asset; (2) managing, buying or selling a specified asset; (3) arranging financing to acquire a specified asset; and (4) any activity that supports these services. “Investment partnership” means any partnership, after two consecutive calendar quarters post-enactment, where substantially all assets are specified assets and less than 75 percent of the partnership’s capital is attributable to qualified capital interests held in connection with the owner’s trade or business. “Specified asset” includes securities, real estate, partnership interests, commodities, cash, options, and derivative contracts.

Senator Baldwin wrote a letter to Senate Finance Committee Chairman Orrin Hatch (R-Utah), in anticipation of the Senate’s release of its tax reform bill, urging him to include her carried interest bill in the Senate’s tax reform package. Senator Baldwin noted that the Brady amendment to the House tax reform bill would not completely close the carried interest loophole because most such interests are held longer than the proposed lengthened holding period and firms that rely on the loophole could still avoid payroll taxes. “I agree with President Trump, this loophole for hedge fund managers on Wall Street should be closed and we should work together to help him keep his promise,” said Sen. Baldwin.

Restricted stock units. The Brady amendment also would protect interests of employees holding stock options or restricted stock units at early-stage companies. The amendment would allow these employees to defer recognition of some income for up to five years. But qualified employees receiving qualified stock would make an election to defer income and must be employed by, and perform services for, an “eligible corporation,” which is defined as a company whose stock is not traded on an established securities market and which had a written plan stating that at least 80 percent of its U.S. employees in a calendar year are granted stock options or RSUs, with the same rights and privileges to receive qualified stock. “Same rights and privileges” is subject to further definition by the amendment.

Representative Erik Paulsen (R-Minn) emphasized the benefits of the amended provision for persons who work at start-up companies. He said under current law, these employees face a high tax bill upon expiration of their options or RSUs because there is no market for their shares. According to Rep. Paulsen, the amendment will foster U.S. innovation and promote employee ownership.