House Passes Carried Interest Provisions

What does it mean for PTPs?

 

 

The House of Representatives passed on December 9, by a vote of  241-181, a bill containing the carried interest legislation introduced in April by Rep. Sander Levin (see our earlier story, Rep. Levin Introduces New Carried Interest Bill).  The Tax Extenders Act of 2009, H.R. 4213, extends a number of expiring tax provisions benefitting both businesses and individuals and uses the carried interest provisions, which raise an estimated $24.6 billion in revenue, to pay for the extensions.

Investors in PTPs may have concerns about this legislation, particularly in light of a December 10 Wall Street Journal editorial on the bill asserting that "managers of real-estate and oil-and-gas partnerships would also get socked with [a] 133% tax-rate increase."  Below are some questions and answers regarding the effect of the provision, should it be enacted, on PTPs and their investors.

What does the carried interest legislation do?

The legislation provides that all carried interest received in exchange for providing investment management services to a partnership will be taxed at ordinary income rates (i..e., a top rate of 35%), even if it is capital gains income.

What is carried interest?

Carried interest is a share in the profits of a partnership given to its general partner or other managers (for example, the managers of an investment partnership, hedge fund, or private equity fund, etc.) in exchange for their management services.  In partnership tax jargon, it is more commonly referred to as a "partnership profits interest."  If you buy a share in a partnership, you receive both a capital interest--your share of ownership that you paid for--and a profits interest, your share of the profits earned by the partnership.  A carried interest is a profits interest without the capital interest, although partnership managers often have capital interests as well.

Why is Congress concerned about carried interest?

It's complicated, and has to do with the way partnership taxation works.  If you have an interest in a partnership--whether it is a regular ownership interest or a profits interest -- you are allocated a share of that partnership's income.  The income in your hands has the same character (e.g., capital gain vs. ordinary) that it does in the partnership's hands, and you are taxed on it accordingly (for more on how PTP investors are taxed, click here).   Some investment partnerships, particularly in the private equity industry, earn mostly capital gains by buying and selling shares in other companies.  The managers of these companies thus receive their carried interest in the form of capital gains and pay capital gains tax rather than ordinary income tax. 

What many policymakers object to is the fact that the carried interest paid to partnership managers is really compensation for their management services.  An ordinary worker receiving an hourly wage or a salary as compensation for his services pays tax on it at ordinary income rates.  These policymakers believe that this is unfair to the ordinary worker and bad tax policy for some compensation to be taxed at ordinary income rates and other compensation taxed at capital gains rates, particularly when the people paying the lower tax rate tend to be on the upper end of the income scale. They feel that all compensation for services should be taxed at ordinary income rates. That is why a bill was written to treat all carried interest as ordinary income even if it would otherwise be capital gains.  

There are also many policymakers who disagree with this approach, feeling that the lower capital gains rate appropriately reflect risks that managers take in establishing and building up businesses and making them profitable. They point out that while the ordinary wage earner is paid a fixed salary, carried interest depends entirely on the manager's making the business profitable. They believe that the way profits interests are treated under the tax law should not be changed.  However, those taking this view are currently in the minority in the House of Representatives.

Do PTP managers receive carried interest?

The general partners of many PTPs receive "incentive distribution rights" (IDRs), which gives them an increasing share of distributions as distributions to the common unitholders increase.  The IDRs are a form of carried interest.

So how does the bill affect PTPs and their managers?

The PTPs that most people invest in, the ones operating pipelines, oil and gas production facilities, refineries, propane companies, and other energy related businesses, would not be affected if this bill passes.  In particular, the Wall Street Journal is wrong to imply that managers of all oil and gas partnerships would see their taxes increased under this bill.  That is because the carried interest received by managers of these PTPs does not take the form of capital gains.  These PTPs have operating businesses that generate ordinary income, and so their managers receive ordinary income as well.   There are a few technical issues regarding the way the bill affects PTP general partners that are PTPs themselves, which the Association has been working to correct, but the basic fact is that the carried interest (the IDRs) of general partners and managers of energy PTPs has always been ordinary income, and this bill would not change their taxation.  And the way the common unitholders of these PTPs are taxed would not change at all.

There are some PTPs that would be affected.  These are PTPs whose main business is to provide investment management services.  Under the bill passed by the House, the managers of these PTPs might see taxation of their carried interests change if they had been receiving capital gains.  Moreover, the bill states that these PTPs providing investment management services will no longer qualify for partnership tax treatment under section 7704 of the tax code (for more information on which PTPs can be taxed as partnerships, click here).  Those already in existence would have ten years from the date of enactment to operate under current law.

What happens next with this bill?

The next step is for the bill to be passed by the Senate.  While the Senate is in agreement on extending the expiring tax provisions, there are many Senators, both Republicans and Democrats, who object to the carried interest provisions.  It is considered unlikely at this time that the Senate will agree to include them in its bill or in the final version of the Tax Extenders Act.  However, because the bill raises a substantial amount of revenue, it could come up again later as Congress searches for ways to pay for tax cuts or federal programs and to reduce the budget deficit.

 

For more FAQs on the carried interest issue, click here.