On December 9, 2009, the House passed a new tax bill, entitled the Tax Extenders Act of 2009, which would, among other things, change the tax treatment of performance allocations. Under the proposed bill, income derived from a service provider’s “incentive allocation” or “carried interest” in an investment partnership would be taxed as ordinary income (as opposed to the current capital gains treatment) that is subject to self-employment taxes.
This new requirement would apply to the extent an incentive allocation or carried interest relates to income earned by a partner through investment management activities, and not to any income or gain that reflects a reasonable return on investments (which presumably means that any income or gain earned by a partner’s actual investment in the partnership would continue to be taxed as capital gains, whereas any “special” allocations which are meant to compensate a partner for investment management services provided to the partnership would be taxed as ordinary income. Partners will fall under this provision if they advise a partnership as to investment decisions regarding certain assets, manage certain assets, arrange financing to acquire such assets, or otherwise support the provision of such services. The types of assets include securities, real estate held for rental or investment, interests in other partnerships, and commodities and option or derivative contracts issued in connection with such assets. This provision generally will apply to taxable years ending after December 31, 2009, with certain sections becoming effective on other dates.
Please refer to the alert posted on the website of the law firm of Schulte Roth & Zabel LLP for a more in-depth discussion of the proposed bill, including other provisions that might be relevant or applicable to private investment funds and/or their advisers.
At this point, the House bill still needs to be approved by the Senate, and the Senate has not indicated whether it intends to pass a tax bill by year-end, or whether any or all of the provisions of the House bill would be included. However, if Congress ultimately passes a law that converts the treatment of performance allocations to from capital gains to ordinary income, it could have a significant impact on the current fee structures of many private investment funds organized as limited partnerships.
