The Current Debate About The Federal Income Tax Treatment Of 'Carried' Interests – Status And Possible Approaches

Ever since word leaked that the Senate Finance Committee was studying the federal income tax treatment of "carried" partnership interests, there has been much speculation but little information about what legislation addressing this controversial area might do. Our understanding is that this study is in the early stages, as has been reported in the media, and there is no "proposal", despite rumors to the contrary. Instead, the study has been going on at the staff level - Congressional tax staffs are currently gathering information to determine whether, and if so how to act. We suspect that this process will take months and may even see Congressional hearings on the topic.

Anticipating a continued interest in this issue, we thought it might be helpful to inform clients about the parameters of the current debate and what we think are realistic possibilities for legislative action. What follows are guesses and only guesses. Congress, as usual, will have the last legislative word.

Background On a technical level, the current controversy stems from the fact that a service partner (such as a general partner managing an investment partnership) can take his or her carried interest (i.e., the right to share in appreciation of fund investments) at capital gains rates. Thus, for example, in the typical domestic venture capital or private equity fund, the GP is entitled to a management fee equal to a specified percentage (e.g., 2%) of capital commitments per annum and a carried interest equal to a specified percentage (e.g., 20%) of realized gains. A 2 percent annual management fee may be taxed to individual members of the GP at today's 35 percent ordinary income rates. The 20 percent, if earned as long-term capital gains by the fund, is taxed to individual members of the GP at today's 15 percent preferential capital gain rate. Such a carried interest is just one variation of a broader category of partnership interests, "profits interests", where a partner's share of profits is greater than its share of capital.

There has been a longstanding debate in the tax community whether the receipt of a profits interest, such as a typical carried interest, results in gross income to the service partner when received. Through a series of cases (including Sol Diamond1 and Campbell v. Commissioner2) and administrative guidance,3 however, the law is relatively well settled that, except in very unusual circumstances, receipt of a profits interest does not result in...