House Tax Extenders Legislation Would End Capital Gains Treatment of Carried Interest

Legislation slated for House passage would mandate the end of capital gains treatment of carried interest earned by hedge funds and other asset managers as a way of paying for the extenders in the Tax Extenders Act of 2009, HR 4213. The measure would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. It would require such managers to treat carried interest as ordinary income received in exchange for the performance of services to the extent that carried interest does not reflect a reasonable return on invested capital. The bill would continue to tax carried interest at capital gain tax rates to the extent that carried interest reflects a reasonable return on invested capital. This is consistent with the proposal to change the tax treatment of carried interest that is included in the President’s FY2010 Budget This provision has previously passed the House of Representatives on two occasions.

Hedge and private equity funds are typically structured as partnerships for federal tax purposes. Managers of these funds often receive an asset-based management fee of 2 percent of the fund’s committed capital and an interest of 20 percent in the profits of the fund. The 20 percent profits interest is referred to as the carried interest. For managers of private equity funds and hedge funds, the carried interest often represents a substantial portion of their total return from the funds.

Upon receipt of the carried interest, the fund manager becomes a partner in the fund and pays tax in the same manner as other partners on his distributive share of the fund’s taxable income. The character of the income included in the manager’s distributive share is the same as the character of the income recognized by the fund. Thus, if the fund earns ordinary income or short-term or long-term capital gain, each partner’s distributive share includes a portion of that income. For example, if the fund sells stock of a portfolio company that it has held for more than a year, the manager’s share of the long-term capital gain is taxed at the 15-percent federal long-term capital gain rate.

The House believes that carried interest is money earned on a service provided by fund managers, not money earned on their personal investments.The hedge fund managers will still get capital gains treatment on that portion of the profits representing their own money in the funds they manage. In other words, capital gains tax treatment will still be available to the extent that gain is attributable to the manager’s invested capital. But the compensation for services portion of the carried interest would be treated as ordinary income.

After House passage, the measure will go to the Senate, where there is likely to be opposition to the carried interest provision. Just before the 2008 August recess, cloture on an extenders bill was rejected by a party-line vote, with 43 Republicans opposing cloture. In a letter to Senate Republicans, the Managed Funds Association said that provisions of the bill would adversely affect the competitiveness of U.S.-based hedge fund managers.

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