Taxation of Carried Interest: What the Future Holds

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1 Taxation of Carried Interest: What the Future Holds Recent tax law changes have increased taxes in general on compensation received by managers of hedge funds and private equity funds through the implementation of new payroll taxes and higher tax rates across the board. Trend Congress continues to focus on carried interest taxation, as evidenced by the reintroduction of legislative proposals to tax these interests as ordinary income. Overview Recent tax law changes have increased taxes in general on compensation received by managers of hedge funds and private equity funds through the implementation of new payroll taxes and higher tax rates across the board. The enactment of additional tax proposals specifically targeting carried interests would further magnify these tax liabilities for both income and estate tax purposes and likely affect how managers conduct their management activities and structure their compensation plans going forward. Planning Opportunity Since fund managers face an increased tax burden both on their compensation and their estates, planning should take place immediately on both fronts. If passage of any proposed carried interest legislation becomes imminent, managers will want to act promptly to review and restructure their compensation arrangements (e.g., to receive in-kind compensation) or to consider selling their carried interests to an affiliate to accelerate capital gains recognition. Managers also should anticipate significant estate tax exposure and consider life insurance as an option for offsetting their liability in a relatively simple and tax-efficient manner. Understanding Carried Interests Most hedge funds and private equity funds (hereafter referred to collectively as funds ) are structured as partnerships in which investors become limited partners and the funds managers are general partners. As general partners, the managers are typically classified as self-employed individuals. These managers typically take a significant portion of their compensation as a share of the funds profits, which is referred to as a carried interest. In what is commonly known as the 2/20 structure, managers are entitled to a yearly 2 percent management fee (computed based on value of the assets being managed as of the end of the year) and 20 percent of the yearly gains. Example 1: Calculation of Fund Manager s Compensation A fund has 1) a portfolio of $50 million in assets (mostly securities), 2) five limited partners (each of whom invested $10 million) and 3) an individual manager serving as the general partner. The manager is entitled to 2/20 compensation. Investors are guaranteed a 10 percent return. During the year, the fund makes a profit of $50 million. At the end of the year, each investor will receive $5 million, leaving $25 million of profit. Compensation: The manager receives $2 million as a management fee and 20 percent of the remaining $23 million ($4.6 million), for total compensation of $6.6 million. The balance is distributed to the investors. White Paper continues >

2 Page 2 of 5 White Paper Current Taxation of Carried Interests Income and Capital Gains Taxes Partnership gains and losses generally are not taxed at the partnership level; instead, partners are taxed on their share of partnership gains and losses. The character of that income is determined at the partnership level and flows through to the partners. Thus, if the gains from the fund s underlying assets are long-term capital gains, the managers, as general partners, can take advantage of the current 20 percent long-term capital gains rate on their carried interest allocations. The 2 percent management fee is taxed as ordinary income. Medicare Contribution Tax (Medicare tax) As of 2013, the 3.8 percent Medicare tax on net investment income will increase the tax burden on certain types of passive income, including capital gains. 1 Importantly, for carried interest purposes, net investment income includes income from a trade or business that is a passive activity or a trade or business in financial instruments and commodities. Most funds fall under one of these two categories. Self-employment Taxes Self-employment taxes (SE taxes) are Social Security taxes and hospital insurance taxes that individuals pay on net earnings from self-employment (SE income). As of 2013, SE taxes apply as follows: 1) 2.9 percent on all SE income (the hospital insurance tax portion), 2) an additional 12.4 percent on the first $113,700 of SE income (the Social Security tax portion) 2 and 3) an additional 0.9 percent on SE income over specified thresholds ($200,000 for single filers; $250,000 joint filers) as an additional hospital insurance tax portion. 3 SE taxes may apply to general partners in a partnership (or members in an LLC), but typically not to limited partners. As most fund managers are, in substance, general partners, their income could be subject to SE taxes. To avoid these taxes, fund managers may seek to 1) structure the carried interest as a partnership allocation and not as a fee for services or 2) simply title themselves as limited partners under state law. The application of the new Medicare tax to carried income, however, achieves almost the same result as if the carried interest had been treated as SE income to which the SE taxes applied. Example 2: Parity in Application of Medicare and SE Taxes An unmarried fund manager has total income of $1 million of carried interest and $500,000 of management fee. Carried Interest Not SE Income: Manager pays Medicare tax of $38,000 (3.8 percent of $1 million) and SE taxes of $31,299 (2.9 percent of $500, percent of $113, percent of $300,000) for a combined liability of $69,299. Carried Interest as SE Income: No Medicare tax applies, and the entire $1.5 million is subject to SE taxes of $69,299 (2.9 percent of $1.5 million percent of $113, percent of $1.3 million), for a combined liability of $69,299. Note: This tax parity between the earned income and passive income was exactly what Congress wanted to achieve. It is likely that any legislation pertaining to carried interest will leave this parity in place. Proposal to Change Taxation of Carried Interests The Carried Interest Fairness Act (2012) The Carried Interest Fairness Act (the CI Proposal) 4 would treat income attributable to investment services partnership interests as ordinary income. As a result, fund managers who receive carried interest would be subject to ordinary income tax and SE taxes on such compensation (although the capital gains rate would continue to apply to the extent that a manager s income represented a return on capital they invested in the fund). In addition, subject to certain exclusions, gain from the sale of the carried interest will be re-characterized as ordinary. For ordinary income treatment to apply: Substantially all of the assets of the fund (other than certain intangible assets such as goodwill) must be specified assets (e.g., securities and real estate). More than 50 percent of the fund s capital must be attributable to contributions by one or more persons in whose hands the interests constitute property held as an investment (as opposed to a trade or business). 5 The carried interest must be held or acquired in connection with the conduct of a trade or business primarily involving the performance of investment, advisory and management services.

3 Page 3 of 5 White Paper The treatment of profits that managers earn when they sell their carried interest (commonly known as enterprise value ) deserves special attention. Under current law, if the carried interest was held for more than a year, the entire gain from the sale should be subject to long-term capital gains rates (i.e., 20 percent). Under prior carried interest bills, gains from sales of carried interest by a manager would be completely re-characterized as ordinary income. Under the CI Proposal, however, if there is a clearly separable and verifiable element of goodwill, such as where there is a separate management entity, the manager receives capital gains treatment for that portion of the gain on the sale, and ordinary income treatment for the rest. Note: The CI Proposal is not law. It is very likely that any final legislation (and subsequent Treasury Regulations thereunder) would differ from the above in various respects. Potential Impact of Proposed Legislation Income Taxation Currently, long-term capital gains are taxed at 20 percent and ordinary income at a top marginal rate of 39.6 percent. If proposed legislation is enacted that taxes carried interest as ordinary income rather than capital gains, that could mean a 98 percent tax rate increase on carried interest income. Example 3: Manager Income Current Law vs. CI Proposal Recalling the manager from Example 1, she received $2 million as a management fee and $4.6 million as carried interest (which, under current law, qualifies for capital gains treatment). Current Law: The manager s total tax liability, including income, capital gains, Medicare and SE taxes, would be roughly $1,921,038 (effective rate of 29.1 percent). CI Proposal: The entire $6.6 million will be subject to ordinary income tax rates and SE taxes. The manager s total tax liability would be roughly $2,834,463 (effective rate of 42.9 percent). Note: The difference is significant, resulting in additional tax liability of $913,425, or 47.6 percent more in taxes. Under current law, fund managers are encouraged to structure their compensation so that as much as possible will be attributed to the carried interest, to take advantage of lower capital gains tax rates. Since any legislation will not result in tax rates that are higher for carried interest than for management fees, this structure is still optimal. Example 4: Manager Gain Current Law vs. CI Proposal With and Without Goodwill A fund manager sells her carried interest and recognizes $10 million of gain. Of that, $3 million is attributable to goodwill. Current Law: The $10 million of gain incurs a 20 percent capital gains tax ($2 million) and the 3.8 percent Medicare tax ($380,000) for a total tax of $2.38 million. CI Proposal with Goodwill: The $3 million of goodwill will be subject to a 20 percent capital gains tax ($600,000) and the 3.8 percent Medicare tax ($114,000). The remaining $7 million will be taxed as ordinary income ($2,727,348) and subject to SE taxes ($278,299), for a total tax of almost $3.7 million. CI Proposal with No Goodwill: The $10 million of gain will be taxed as ordinary income ($3,915,348) and subject to SE taxes ($392,299), for a total tax of almost $4.3 million. To prepare for the possibility of carried interest legislation that accounts for enterprise value, fund managers may want to take actions now to separate and verify the goodwill element of their carried interests. Note the CI Proposal suggests that if the manager is organized as an entity, a presumption of separate goodwill should exist. Thus, managers who do not conduct management activities through an entity and believe that they have significant goodwill may want to consider establishing a separate management entity. Estate Taxation At death, the carried interest held by a fund manager is taxable in his or her estate based on the fair market value of the interest as of the date of death. Under current law, the carried interest receives a basis step-up to date-of-death value, eliminating income tax on any inherent gain. If the CI Proposal passes, however, the amount that would have been treated as ordinary income upon sale by the deceased manager will be treated as income in respect of a decedent (IRD), which is not eligible for a basis step-up. Double taxation effectively results, since the value of the carried interest will be subject to estate tax, with the inherent gain in the interest subject to income tax.

4 Page 4 of 5 White Paper Example 6: CI Proposal with No Goodwill Relief A fund manager dies holding carried interests worth $10 million and with a $0 basis. Estate Taxes: The $10 million will be included and taxed in the deceased manager s estate, up to a top federal estate tax rate of 40 percent. If the manager resided in a state with a separate state estate tax (e.g., New York), the top combined federal and state estate tax rate could reach 49.6 percent and an estate tax liability of $4.96 million. Further, the amount that would have been treated as ordinary income upon sale by a decedent (e.g., $10 million) is taxed as IRD and receives no basis step-up. Thus, it retains its character as ordinary income and will be included in the gross income of the decedent s estate or heirs when collected. Facing significant tax burdens, especially if carried interest legislation passes, clients with carried interests will uniquely benefit from life insurance planning, due to both the ability to generate liquidity to pay the tax burdens and to receive payment of the insurance death benefits estate- and income-tax-free. What s Next? Preparing for Possible Legislation The carried interest proposed legislation is still a moving target. Many things can change between now and the effective date of such legislation, if and when adopted. However, there are a few actions that funds and their managers can take to reduce the impact: Funds should review and amend (if necessary) the relevant provisions of their partnership agreements, especially provisions pertaining to the manager s rights for compensation, transfer of the carried interest by the manger, substitution of cash compensation with in-kind distributions of securities and requests for limited partners approvals. Accelerate all accrued and unpaid carried interest. To the extent such accrued and unpaid interest is attributable to previous years, it should not be subject to ordinary treatment. To the extent the fund accelerates carried interest for 2013 for periods prior to the effective date of legislation, the agreement may be amended to provide for monthly payments instead of an end-of-the-year payment. (Payments attributed to a period prior to the effective date should be treated as capital gain.) Managers may substitute the yearly compensation with in-kind compensation so that they are compensated by receiving securities from the underlying portfolio investments. Managers may sell the carried interest to an affiliate (or a third party); under current law, any gain will be capital if the interest was held as a capital asset for more than one year. Managers must anticipate and plan for the significant estate tax burden generated by owning carried interest at death, as well as the possible IRD/income tax consequences to heirs if the carried interest legislation passes. Life insurance offers a relatively simple and quick-to-implement planning solution to minimize uncertainty and to offset possible tax burdens by providing income and potentially estate-tax-free death benefits. Finally, some funds may consider migrating overseas; however, such actions involve significant tax and regulatory planning. Legal Disclaimer: This information has been prepared for the information and education of NFP and is not intended for use as legal or tax advice. This information cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on such taxpayer. Any client of NFP should consult with their own legal or tax advisors for specific legal or tax advice. Greenberg Traurig, LLP does not sell investment or financial products or provide financial or investment advice. Financial Disclaimer: Any projections and illustrations provided herein are hypothetical approximations only, based on various factual, actuarial and tax assumptions. Actual results will vary and cannot be guaranteed. Greenberg Traurig, LLP does not sell investment or financial products or provide financial or investment advice. Circular 230 Disclaimer: Pursuant to U.S. Treasury Department Circular 230, the tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of avoiding tax-related penalties or promoting, marketing or recommending to another party any matter(s) addressed herein. Endnotes 1 Net investment income generally includes interest, dividends, annuities, royalties, rents, capital gains, passive activity income and income from trading in financial instruments or commodities. It does not include tax-exempt interest and distributions made by qualified pension, profit-sharing and stock bonus plans, qualified annuity plans, annuities purchased by Internal Revenue Code (IRC) 501(c)(3) organizations or public schools, individual retirement accounts, Roth individual retirement accounts and eligible deferred compensation plans. Gain from a disposition of an interest in a partnership or an S corporation constitutes net investment income to the extent of the net gain attributed to the entity s nonbusiness property (IRC 1411(c)(4)(A)). A similar rule applies to a loss from a disposition of an interest in a partnership or S corporation (IRC 1411(c)(4)(B)). In the case of an individual, the Medicare tax will be imposed on the lesser of the net investment income or the excess of modified adjusted gross income over the threshold amount. The threshold amount is $250,000 in the case of a couple filing joint return or in the case of a surviving spouse; $125,000 in the case of married individuals filing separate tax returns; and $200,000 in for any other taxpayers. 2 The Social Security threshold is indexed annually for inflation. 3 Represents the additional hospital insurance tax on earned income in excess of the specified thresholds, as implemented by the Patient Protection and Affordable Care Act. 4 The most recent proposal, introduced on Feb. 14, 2012, died in the House Ways and Means Committee. While carried interest provisions were not included in recently enacted tax legislation (the American Taxpayer Relief Act of 2012), the sponsor of the carried interest bill, Rep. Sander Levin, D-Mich., has made comments indicating that he will bring this carried interest legislation back to the table in Thus, limited partners that are passive investors will still be subject to capital gains.

5 Page 5 of 5 White Paper About PartnersFinancial PartnersFinancial is a national community of industryleading, independent life insurance and financial professionals. For more than 20 years, the organization has supported its members as they build insurance industry knowledge and expertise. In the process, PartnersFinancial members created a powerful culture of idea-sharing and collaboration all for the benefit of their clients. PartnersFinancial members take advantage of the organization s preferred market access and clout to offer clients a comprehensive selection of high-quality insurance and wealth transfer solutions. Members also have access to an extensive range of resources, technology, tools, and knowledge-sharing forums and events. As part of NFP, a national, publicly held insurance, benefits and investments company, PartnersFinancial also offers members access to capabilities that go beyond an individual company s scope. This material was created by NFP (National Financial Partners Corp.), its subsidiaries, or affiliates for distribution by their representatives and/or agents. This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. Neither NFP nor its subsidiaries or affiliates offer tax or legal advice /13 (INS ) Copyright 2013 NFP. All rights reserved.

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