Washington is desperate to raise new revenue, and fund managers are top targets.
Both the Obama administration and members of Congress have proposed to increase taxes on fund manager income from carried interests in the funds they manage. As a result of these proposals, the after-tax return on investments for fund managers could decrease by 30 percent or more. The proposals would affect partners in almost any partnership (or members in almost any LLC) if they perform any financial advisory services for that entity. However, very similar corporate structures are unaffected, and Congress has yet to provide a clear reason why buyout fund managers should be treated differently from corporate owner-managers. While it may be too late to save existing funds, it may yet be possible to structure new buyout funds in a way that protects capital gains on investments.
U.S. private equity funds generally are organized as partnerships or limited liability companies taxed as partnerships. (For purposes of this article, I ignore “blocker” entities put in place for tax-exempt and non-US investors.) Until recently, this structure presented a clear advantage to private equity investors and managers. It avoids tax at the fund level, increasing returns for both investors and managers. Moreover, flexibility in structuring partnerships allows carried interests that give managers a percentage of profits with little or no up-front equity investment, while preserving capital gains treatment for managers when portfolio companies are sold.
Under current law, when a fund sells a portfolio company, the gains are allocated among the various investors (including managers). The character of the gain flows through to the investors, so investors would be taxed at capital gain rates rather than ordinary income rates. When the fund distributes cash to its investors, they are not taxed to the extent they have “tax basis” in the fund. Gains allocated to an investor increase basis dollar for dollar (while losses decrease basis). As long as distributions to an investor are less than the sum of capital invested plus net gains allocated to that investor, the investor will owe no further tax.
The carried interest works by shifting the allocations mid-stream. After outside investors have received their money back, fund managers participate in the fund’s upside, receiving somewhere between 10 percent and 20 percent of the residual profits. In some funds the carried interest works on a portfolio company by portfolio company basis; in others the managers only participate after all capital is returned. In either case, fund managers are taxed like any other investors: generally at capital gain rates. (Management fees are taxed at ordinary income rates; it is only the allocated share of gain from portfolio company sales, along with qualified dividends from those companies, that would be entitled to capital gain treatment.)
Proposed Tax Law
Fund managers present an easy target for legislators looking to arouse populist fervor. In 2007, Democratic Rep. Sander Levin, now acting chairperson of the House Ways and Means Committee, introduced legislation (co-sponsored by then-Chair Democratic Rep. Charles Rangel) that would tax carried interests at ordinary income rates. In the press release announcing this attack, he said, “Investment fund employees should not pay a lower rate of tax on their compensation for services than other Americans. These investment managers are being paid to provide a service to their limited partners and fairness requires that they be taxed at the rates applicable to service income just as any other American worker.”
This sentiment was echoed by other legislators and recurred in other bills. When Rep. Rangel later in 2007 introduced major tax reform (his so-called “mother of all tax bills”), it too would tax carried interests at ordinary income rates. The proposal met with significant resistance from the private sector and from the Bush administration. Before it could be seriously debated in Congress, the financial crisis hit, and the carried interest proposal was put on hold. However, much of Rep. Rangel’s bill, including the attack on carried interests, has resurfaced in the Obama Administration’s budget proposals. This time, if Congress acts, the administration will be behind it.
Now that the worst of the financial crisis seems to be behind us, carried interests are again in Congress’s crosshairs. Several variations of the carried interest legislation were introduced during 2009, and then in December 2009, the House passed an extenders bill, H.R. 4213, that included a carried interest proposal very similar to the 2007 Rangel bill.
This bill, like its predecessors, created a new, broad concept: “investment services partnership interest” and would tax all income from an “investment services partnership interest” at ordinary income rates. All it takes for a person to hold an “investment services partnership interest” is for the person to provide any sort of valuation analysis or management of investments owned by the partnership. Thus, all fund managers who own fund interests by default hold “investment services partnership interests.” The bill had a limited exception for “qualified capital interests”: that portion of a partner’s interest that is attributable to the fair market value of money or other property contributed in exchange for an interest in the partnership. This exception might allow for some flexibility in differential allocations among classes of investments (i.e. providing for some senior and junior equity), but it was likely that any class of junior equity held only by fund managers and that carried a higher “common” return than the non-management equity would not be treated as a qualified capital interest.
The bill included two anti-abuse provisions. The first would prevent use of convertible debt, options, or other derivative instruments to mirror the economics of a carried interest without technically being an “investment services partnership interest.” Any income from such an instrument earned by a person providing investment management services to a partnership would be taxed at ordinary income rates. While stock of domestic corporations generally is excluded from this provision, Treasury would be authorized to issue regulations treating corporate stock as “disqualified interests.” The second was more general, directing the U.S. Treasury Department to draft any regulations necessary to prevent avoidance of the purposes of the carried interest provision.
All of these provisions were supported by a new penalty: 40 percent (rather than the usual 20 percent) on underpayments of tax relating to investment services partnership interests or disqualified interests.
The Senate remains quite resistant to changing the taxation of carried interests. The Senate’s version of H.R. 4213, passed on March 10, did not include carried interest language. Rep. Levin indicated that, because of the strong resistance of the Senate, he does not anticipate the proposed carried interest provisions will be in the final extenders legislation. However, given the provision’s support in the House and the Obama administration, fund managers should expect that taxation of carried interests will change in the near future.
While the carried interest tax proposals have focused on partnerships, they generally have not addressed taxation of corporations. Corporations are a less politically viable target, as Congress would be perceived as acting against small business owners and attacking the middle class; by attacking only fund managers, they can preserve the fiction that they are only attacking “fat cats.”
Corporate management often receives “promoted” junior common equity that is subordinated to investors’ preferred stock or “senior common” stock. After the investors’ preference is satisfied, corporate management participates with the investors in corporate appreciation. Congress and and the Treasury Department long have allowed corporate management to claim the more favorable capital gains rate arising from their sale of the company whose value they built, while limiting ordinary income tax to their annual salary. The current law thus rewards corporate management’s sharing risk with investors by taking a lower salary in exchange for more equity participation.
The “disqualified interest” anti-abuse provision specifically excluded U.S. corporations, and although the Treasury Department could attack the use of corporate structures, it has not yet expressed a desire to do so. Such an attack likely would affect corporate management and create an uproar far greater than fund managers’ response to carried interest legislation.
If corporate managers can receive junior common stock as part of their compensation for work for the corporation, why not fund managers? Private equity funds are not passive investors: They take active roles in management in order to add value to corporations. As such, there is a strong case to be made that they should be treated similarly to corporate managers. The attached figure shows a possible investment structure that should not be subject to the proposed carried interest legislation (though the Treasury Department could issue regulations that would treat the fund managers’ stock investment as if it were a carried interest).
Fund management would invest in each portfolio company alongside the private equity fund and corporate management. The fund would take a senior equity (either a “strip” of preferred and common or a “senior common” whose capital must be repaid before junior common is paid).
Here are some considerations for managers who might use such a structure:
• This structure only works for buyout funds, where the fund (either alone or together with other “club” investors) holds substantially all senior equity investment in its portfolio companies.
• This structure could only work for corporate acquisitions; any junior equity investment in partnerships or flow-through LLCs would be treated as an “investment services partnership interest” and taxed at ordinary income rates.
• Because this structure would operate on an investment-by-investment basis, it would be very difficult to average returns over the entire fund, making the application of customary clawback provisions difficult. Non-management investors likely would resist the structure, at least without some concessions, such as reducing the per-deal carry percentage.
• Unlike a classic carried interest, the junior common stock would need to have some real equity value, but the initial value would be low because of the senior preference. Be careful, though; if the initial junior common purchase price is set too low, the IRS might argue that the common was not in fact a true equity interest but more analogous to a deferred compensation or bonus arrangement.
• The company could issue multiple classes of junior common, perhaps giving corporate management a “subordinated junior” common, in order to more closely reflect the economics of a carried interest at the fund level. However, creating a separate class held only by fund management invites IRS challenge in the event that future Treasury Department regulations specifically target classes of stock held by fund management.
• To keep corporate management from knowing which fund managers own what percentage of the company, or for ease of management, a manager may want its employees to invest in the company through a partnership. If so, that partnership will be subject to the carried interest rules unless it has a single economic class of units, ideally all issued at the same price. If interests are to vary with respect to each portfolio company, a fund manager should consider a separate management investment partnership for each portfolio company.
• This structure will not work well with many existing funds. However, some fund documents may provide the flexibility to restructure existing and future investments to address law changes as long as there is no economic impact to fund investors. If so, the portfolio companies’ capital structure would need to be modified, and managers will need to address a host of tax issues, not to mention possible lender consents.
While carried interest legislation is on hold for now, it does not seem likely to drift far from Congress’s attention. Fund managers would be well advised to assume that carried interests will be taxed at ordinary income rates, if not next year then soon. Any managers planning new funds should consider whether it would be worth restructuring in the event of a law change. While current proposals would not have taken effect until 2011, any final legislation could take effect immediately, or even with retroactive effect, so managers should be ready to act.
A partner in the Philadelphia office of Dechert LLP, David G. Shapiro focuses his practice on the international and domestic tax aspects of mergers, acquisitions, joint ventures, and financing transactions. His practice encompasses entity formation and structure planning, securities offerings and hybrid financings, strategic acquisitions and dispositions, and private equity transactions.