Legislation Ending Hedge Fund Managers Carried Interest Failed at Close of 2009

By James Hamilton, J.D., LL.M., Principal Analyst, CCH Federal Securities Law Reporter; and CCH Derivatives Regulation Law Reporter.

Legislation mandating the end of capital gains treatment of carried interest earned by hedge fund and other asset managers did not pass at the end of the first session of the 111th Congress, but the issue is likely to reappear during the second session in 2010. The carried interest provisions were added as a way of paying for the extenders in the Tax Extenders Act of 2009, H.R. 4213, which did pass the House.

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 legislation would make these changes effective in 2010. 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 previous occasions, and died in the Senate.

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 would 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.

In a letter to Congress, the hedge fund industry opposed the legislation for a number of reasons. For example, said the Managed Funds Association, the extenders legislation would unfairly impact only investment funds holding securities, commodities, derivatives, or real property, with the result that this change in the tax treatment of carried interest would reduce or eliminate the incentives for hedge funds to purchase impaired assets.

Also, the MFA pointed out that the fundamental rationale behind carried interest is that it represents the contributions of intellectual and sweat equity of a partner to a business enterprise. For more than fifty years, the Internal Revenue Code has permitted partners in investment partnerships to pool the capital of investors with the skills of entrepreneurs in joint profit-making enterprises. To align interests and contributions to the partnership, the Code treats a partner's carried interest in the profits on the same terms as the other partners. In the industry's view, legislation changing the fundamental tax treatment of partnerships under the Code would damage the competitiveness of U.S. businesses and capital formation.