PwC alternatives alert, September 20, 2011

Obama's American Jobs Act Bill Contains Carried Interest Offset

On September 12, 2011, President Obama released to the public the legislative text and a brief technical explanation of the American Jobs Act (AJA). Among the revenue raisers added to offset the cost of the jobs stimulus plan is a modified version of the carried interest legislation introduced in prior legislative sessions of the Congress.

Section 412 of the AJA would add section 710 and related provisions to the Internal Revenue Code, dealing with special rules for partners providing investment management services to or on behalf of certain partnerships. The provisions would apply for taxable years ending after December 31, 2012, with a special rule for tax years that straddle December 31, 2012 and with effective dates for distributions and dispositions occurring after December 31, 2012. The special rule for loan repayments (described below) allows a loan repayment occurring before January 1, 2013 to be treated as qualified capital.

Proposed section 710 generally treats the distributive share of income or loss from an investment services partnership interest (ISPI) that would otherwise be net capital gain or net capital loss under section 702(b) as ordinary income or ordinary loss. The net capital loss recharacterized as ordinary income would be limited to previously recharacterized net capital gain. The proposal also denies the benefits of qualified dividend income treatment and does not allow a dividends received deduction under sections 243 or 245 for any dividends allocated to an ISPI. The proposal does not change the treatment of items of expense that would otherwise be treated as section 162 or 212 expenses. Rather, the proposal recharacterizes net capital gain or net capital loss as ordinary income and requires gain recognition in certain cases where gain would not otherwise have been recognized under the Internal Revenue Code.

Unlike the previously introduced legislation which recharacterized only a portion of income (75% under the most recent Senate proposal) allocated to individuals, all capital gain would be recharacterized as ordinary income under this proposal. The loss suspension rule of prior proposals, whereby the loss in excess of prior income inclusions would be suspended, is not contained in this proposal. By deleting the loss suspension rule contained in prior proposals, this change should provide relief to all partners, including C corporation partners, that would otherwise be subject to section 710.

The proposal also treats the disposition of an ISPI as ordinary income and require gain recognition notwithstanding any other rule of law. The proposal does not require gain recognition for gifts to charity or for transfers to related parties [in the latter case because the partnership interest in the hands of the related party would be, by definition, an ISPI]. There is also an exception to gain recognition for transfers to another partnership and for technical terminations, mergers and divisions provided that the transferee entity complies with certain reporting requirements and the interest issued in exchange is treated as an ISPI.

The proposal generally treats the distribution of property in kind as if it had first been sold by the partnership and the gain allocated to the distributee partner as ordinary income. The tax basis of the distributed property is then increased to its fair market value.

The key to the application of proposed section 710 is whether the issued partnership interest is an ISPI. An ISPI is an interest in an "investment partnership" where the interest in the partnership was acquired or held by any person, or a related person to that person, in connection with the conduct of a trade or business by such person. The term "related person" is defined by reference to section 267(b) or 707(b). For this purpose, an interest is acquired or held in connection with a trade or business where the trade or business "primarily" [not a defined term] involves the performance of designated services with respect to assets held directly or indirectly by the partnership. The designated services are for advising, managing, disposing, arranging financing for and supportive services with respect to "specified assets". Specified assets are section 475 securities, real estate held for rental or investment, interests in partnerships, commodities, cash or cash equivalents, or options or derivative contracts with respect to the foregoing.

An "investment partnership" is tested on a quarterly basis starting in 2013. Once a partnership meets this test, it will be treated thereafter as if it always met this test. An investment partnership is a partnership where substantially all [not a defined term] of the partnership's assets are specified assets [not counting section 197(d) intangibles for this purpose], and more than half of the partnership's contributed capital is issued in exchange for interests in the partnership that are held "for the production of income" [elections under section 475(e) or (f) are not taken into account for this purpose].

This definition, which is a change from prior proposals, should more carefully tailor section 710 to more traditional funds with carried interests as compared to prior proposals which treated an interest as an ISPI regardless of the significance of the partnership's holdings of specified assets [a single specified asset could have caused the rule to apply; this will no longer be the case under this proposal] and more than half of the capital of the partnership now needs to be investment capital. Accordingly, pure management companies that do not hold specified assets would be exempt from the provisions of section 710. Thus, much of the "enterprise value" associated with a traditional fund group should not be subject to the provision.

If the partnership interest constitutes, in whole or in part, a "qualified capital interest" (QCI), then allocations, distributions and dispositions of ISPIs are not subject to section 710. In the case of allocations, the allocations have to be made "in the same manner" as allocations to non-service partners in the partnership and those partners cannot be related to the service partner. There are also special exceptions to this allocation rule for (i) no or insignificant allocations to non-service partners, (ii) lower returns on QCIs as compared to non-service interests, (iii) flow throughs in the case of tiered partnerships, and (iv) a no self-charged carry exception. These exceptions were contained in the latter prior proposals dealing with section 710.

A QCI is equal to the FMV of contributed property [without regard to section 752(a)], section 83 inclusions, and the excess net income allocations to the partner, and is reduced by net losses and distributions to partners. These adjustments are not limited to items in periods occurring after the effective date but, rather, apply to items for all years of the partnership's existence.

The amount of QCI is not increased or decreased as a result of a termination of the partnership or a merger, consolidation or division of the partnership. Special rules treat loans by the partnership to the service partner or a related person as not being QCI and for loans by non-service partners to be treated as contributions so as to dilute the QCI of the service partners.

A special rule would treat interests that replicate a partnership interest as if it were an ISPI.

A special rule treats an ISPI as section 751 property in applying section 751(a) or 751(b).

Carried interest income would generally not constitute qualified income of a PTP after a 10-year grace period. There are also special rules here for UPREITs and for certain tiered partnerships.

If there is a violation of any regulations written to prevent the avoidance of section 710, the penalty will be 40 percent and not 20 percent under section 6662, and there will only be a reasonable cause exception to the penalty if there is disclosure of the position and the taxpayer is more likely than not to prevail on the merits. Disclosure is thus mandatory to avoid the penalty.

Section 710 income and loss is taken into account in applying the SECA tax.

Under the proposal, once classified as an investment services partnership interest, all items of income, gain, loss and deduction allocated to such interest would be taken into account in applying the SECA tax.

Section 411 of the AJA would amend section 83 of the Internal Revenue Code to (1) treat the fair market value of a partnership interest issued for services as equal to the liquidation value of the interest, and (2) deem a section 83(b) election to be made unless the taxpayer affirmatively elects otherwise.

Although some improvements have been made as compared to prior proposals, the carried interest proposal contained in the AJA, if enacted, will still be extremely complicated to implement. It is unclear what the political fate of this proposal will be. House Republican leaders have already expressed their disagreement with the proposed legislation.

We encourage you to consult your PwC tax advisor if you have further questions regarding this alert.