Challenge to Tax Treatment of Carried Interest

June 26, 2007

A bill introduced in the U.S. House of Representatives on Friday, June 22, 2007, by Rep. Sander Levin (D-MI), House Ways and Means Chairman Charles Rangel (D-NY), Financial Services Committee Chairman Barney Frank (D-MA), and 11 members of the House Ways and Means Committee could fundamentally alter the tax treatment of “carried interest” payments received by the managers of hedge funds, private equity funds and other private investment vehicles.  The bill would require managers to pay ordinary income-tax rates of as much as 35 percent on capital gains generated by carried interest distributions, rather than the present 15 percent capital gains tax rate.  Carried interest distributions, otherwise known as incentive allocations, are intended to reward managers for successfully generating positive returns on funds’ investment portfolios.  Capital gains treatment would still apply, however, to the extent that the manager’s income represents a reasonable return on capital actually invested.

In a statement released last Friday, Rep. Levin said that “Congress must ensure that our tax code is fair…Investment fund employees should not pay a lower rate on their tax compensation for services than other Americans.  These investment managers are being paid to provide services to their limited partners and fairness requires they be taxed at the rates applicable to service income just as any other American worker.”

This bill is not, however, the only attack on the fairness of the taxation of the compensation of managers of private investment vehicles.  Less than two weeks ago, Senate Finance Committee Chairman Max Baucus (D-MT) and his Republican counterpart Senator Chuck Grassley (R-IA) introduced legislation that would tax all publicly traded partnerships that receive income from investment services in the same way that corporations are taxed on income received from investment services.

It is expected that the House Ways and Means Committee will hold a hearing on the issue of “tax fairness,” which will include discussion of these two bills, when it returns from the July 4th recess.

While it is still unclear as to how these taxation issues will ultimately be addressed, there is a distinct possibility that an omnibus alternative investment taxation bill may be put forward to address the PTP, carried interest and UBIT taxation issues.  This may be particularly attractive to the Democrats as a way to, in one stroke, finance a re-set of the AMT levels.

For more information about this e-Alert, please contact Tony Perricone, Chair, Fund Services Group (212.398.5290 or aperricone@sonnenschein.com), Mike McNamara, Chair, Public Law & Policy Strategies Group (202.408.6477 or mmcnamara@sonnenschein.com) or your regular Sonnenschein contact.

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