3. Proposed Legislative “Solution” – Key Elements<br /><ul><li>K-1 income and loss from an investment services partnership interest (ISPI) would be ordinary income.
4. Outside gain from an ISPI—e.g., from sale of the interest—would also be ordinary. Outside losses would also be ordinary, subject to a limitation.
5. Net K-1 losses from a given ISPI would be allowed only to the extent of cumulative net income from prior years (excluding years before the effective date), with a carryover for unused losses.
6. An individual with an ISPI who is engaged in the investment services business (as defined) would be subject to self-employment tax on all above ordinary income, even where the underlying partnership income was LTCG. Top marginal federal tax rate on such income would go to 42.5%.
9. Carried Interest Legislation – History & Status<br /><ul><li>Has been passed three times by the House, beginning in 2007.
10. Most recent passage was in December 2009 as part of H.R. 4213, Tax Extenders Act of 2009.
11. Carried interest provision similar to the most recent House-passed bill is in the Obama administration budget proposal for FY 2011.
12. Joint Committee on Taxation has scored the proposal as raising $10.5 billion of revenue over five years.
13. Although Senate Democrats have in prior rounds held back the proposal—primarily because of the fundamental change to partnership taxation without a comprehensive policy study—a need for $27 billion to “pay for” revenue losers in the pending tax extenders bill has led some to reconsider.
15. Investment Services Partnership Interest (ISPI) Defined<br />Any interest in a partnership held directly or indirectly by any person if at the time of acquisition it is reasonably expected that such person or a related person would provide a “substantial quantity” of any of the following services with respect the partnership’s assets (including assets held indirectly):<br /> <br /><ul><li>Advice re the advisability of investing in, purchasing or selling any specified asset
16. Managing, acquiring or disposing of any specified asset
17. Arranging financing with respect to the acquisition of specified assets
18. Any activity in support of the above services.</li></ul> <br />Specified Assets Defined<br /><ul><li>Securities (specially—and broadly—defined)
23. Qualified Capital Interest (QCI)<br /><ul><li>The portion of the partner’s interest in capital that is attributable to:
24. Money or property contributed to the partnership in exchange for such interest. Constructive contributions under Sec. 752, relating to allocation or assumption of partnership debt, do not count.
25. The amount included in income under Sec. 83 with respect to the interest
26. The excess of K-1 items of income and gain over items of deduction and loss with respect to the interest for taxable years to which the new legislation applies
27. QCI is reduced by distributions for years to which the new legislation applies, and by allocated net losses for such years.
28. In general, income or gain attributable to a QCI is exempt from carried interest treatment providedthat: (i) allocations of items to the QCI are made “in the same manner” as allocations to other QCIs held by partners who do not provide tainted services and are not related to the service partner whose QCI is being tested; and (ii) the allocations to such other QCIs are significant compared to the allocations to QCI being tested.
30. Qualified Capital Interest: Effect of Partner Loans & Guarantees<br /><ul><li>For purposes of the QCI exception, capital contributions do not count to the extent made “in connection with” a loan or advance made or guaranteed, directly or indirectly, by another partner, the partnership, or a party related to either.
31. For purposes of the QCI exception, if a non-service partner (or a related party) (NSP) makes or guarantees a loan or advance to the partnership, that amount is treated as capital.
32. For example, if SP and NSP each contribute $100, but NSP also loans the partnership $200, then for this purpose total capital is $400, and the SP is considered to have only a 25% interest in partnership capital exempt from carried interest treatment.
34. Investment Management Services Defined<br /> A substantial quantity of any of the following services:<br /><ul><li>Advice re the advisability of investing in, purchasing or selling any specified asset (e.g., securities, investment real estate)
35. Managing, acquiring or disposing of any specified asset
36. Arranging financing with respect to the acquisition of specified assets
38. Basic Carried Interest Rules (new IRC Sec. 710)<br /> <br /><ul><li>Income from an Investment Services Partnership Interest (ISPI) is ordinary income…
39. Except to the extent attributable to the partner’s qualified capital interest (QCI).
40. Loss is ordinary, but can only be deducted to the extent of aggregate net positive income from the same interest for prior partnership years (excluding years before the effective date). Unused losses carry forward and do not reduce outside basis until used.
41. Gain from disposition of an ISPI is also ordinary income.
42. Gain is recognized on disposition, even where a nonrecognition rule would otherwise apply—e.g., contribution of the interest to a corporation or another partnership.
43. Loss from disposition is ordinary, but only to the extent of aggregate net positive income previously treated as ordinary under the carried interest rules.
44. Any amount treated as ordinary income under these rules is also self employment income.
46. Distributions of Property to the Holder of an ISPI<br /><ul><li>Generally, partner recognizes ordinary income to the extent of any appreciation in the property distributed.
47. Excluded from this treatment is appreciation already taxed as ordinary income under the “hot asset” rules of Sec. 751(b). For purposes of the Section 751 rules, an ISPI is treated as an inventory item.
48. To the extent FMV of distributed property exceeds partner’s outside basis (as adjusted to reflect the above income inclusion), partner has ordinary income.
49. If partner later sells the partnership interest at a gain that is also ordinary.
50. No adjustment to the basis of remaining partnership property under Sec. 734(b) to reflect the above income inclusion.
52. Treatment of Disqualified Interests <br /><ul><li>Ordinary income treatment applies to income with respect to a “disqualified interest” held by a person who provides investment management services where the value of the interest held is substantially related to performance of the assets being managed.
53. Example: An option to acquire a partnership interest, where the option holder manages assets of the issuing partnership.
54. Another example (from legislative history): Stock in a Cayman Islands corporation that owns an interest in a hedge fund managed by the holder of such stock.
55. Another example: Participating debt in a partnership whose assets are managed by the holder of such debt.
57. Carried Interest Legislation - Other Provisions<br /><ul><li>40% Penalty. A special 40% accuracy-related penalty applies to underpayments attributable to violation of the carried interest rules. A “reasonable cause” exception applies where all of the following are true:
58. Relevant facts are adequately disclosed;
59. Position is (or was) supported by substantial authority; and
60. Taxpayer reasonably believed that the reported treatment was more likely than not proper.
61. Publicly-Traded Partnerships. Ordinary income under the carried interest rules is not qualifying income for a PTP.
62. Exception for certain PTPs controlled by a publicly-traded REIT
63. Application of the PTP rule is delayed 10 years for existing PTPs.
64. Deemed Section 83(b) election. Where a partnership interest is transferred in connection with providing services to the partnership (or for its benefit), the SP is deemed to have made a section 83(b) election absent an election out.
65. Applies to all services, not just investment management services (i.e., is not limited to carried interests).