Pure Carried Interest on Brink of Extinction (Patrick Murphy Commentary)

Absent congressional action, the “fiscal cliff” we are expected to plunge from on the first day of the new year has numerous facets.

The most familiar are increases in the individual income tax rates (from 35 percent to 39.6 percent at the top), capital gains tax rates (from 15 percent to 20 percent), dividend tax rates (from 15 percent to marginal tax rates) and estate tax rates (from 35 percent to 55 percent), as well as a decrease in the applicable exclusion amount from $5.12 million to $1 million.

With this said, one component that may harm numerous unsuspecting Arkansans is the taxation of income derived from a profits interest, better known as “carried interest.”

Carried interests are quite common in business ventures using either the limited liability company or partnership structure. A carried interest arises when an individual enters into a partnership — or an LLC taxed as a partnership — without investing any capital but with the promise of a share of future profits in exchange for the individual’s services.

Currently the law does not tax the entering partner upon the initial receipt of a carried interest. By contrast, if an entering partner receives a capital interest in the partnership in exchange for services — meaning an immediate liquidation of the partnership would entitle such partner to receive a portion of the distributed capital — the current law treats this as a taxable event. The fair market value of the capital interest received is immediately taxed as ordinary income.

Currently, the character of income at the partnership level flows through to the partner when tax time rolls around — ordinary income for the partnership is taxed as ordinary income for the partner, and a capital gain for the partnership is taxed as a capital gain for the partner.

While preserving the character of the income has been a basic tenet of tax law, legislation introduced in the U.S. House and included in Senate proposals would ignore this tenet when it comes to carried interests. Carried interests would be renamed “investment service partnership interests”; 75 percent of income derived from such interests would be treated as ordinary income, and the remaining 25 percent would be taxed at capital gains rates. Moreover, President Obama’s fiscal year 2013 budget proposes to tax all income derived from carried interests at ordinary income rates.

The stated intention of the Obama administration is to prevent certain financial managers from paying a lower tax rate on their service-oriented income than other workers who must pay ordinary income rates on their respective wages for services.

The reform proposals have been crafted with an eye toward Wall Street, ignoring myriad unintended consequences for other sectors, such as real estate. Real estate partnerships invest in office buildings, apartments, shopping centers, hotels and industrial structures all across our state, and most are structured with some form of carried interest component. A tax increase on carried interest could discourage entrepreneurial real estate activity because the developer-partner would then bear a substantial portion of economic risk with a smaller portion of the financial upside. When there is no incentive for real estate developers to build, economic growth is hampered and job creation is stifled.

It is unlikely the initial receipt of a carried interest will ever be taxable immediately; it would be unfair and even impossible to tax the present value of a speculative stream of future profits.

However, the days of carried interests being taxed solely at favorable capital gains rates are almost certainly gone. Whether the 75/25 ratio is implemented or the president succeeds in taxing 100 percent as ordinary income, investors should expect a change in the taxation of carried interests in the near future.

Investors are well advised to be leery when entering into partnership arrangements in which no capital is invested in the venture and the only compensation for your services is an interest in future profits. This could result in the creation of ordinary income that was once taxed as a capital gain.

(Patrick H. Murphy is a transactional attorney with Quattlebaum Grooms Tull & Burrow PLLC in Little Rock. He can be reached via email at PMurphy@QGTB.com.)