United States: Senators introduce bill aimed at radically altering the tax consequences of carried interest

In brief

In his American Families Plan, President Biden called for carried interest, the interest in a fund’s profits granted to a fund manager, to be taxed as ordinary income rather than capital gain. Earlier this month, Democratic Senators upped the ante by introducing a bill that proposes to also end deferral of carried interest recognition, whether or not there has been a realization event, and tax deemed compensation to fund managers as ordinary income.


Contents

In more detail

On 5 August 2021, Senate Finance Committee Chair Ron Wyden, D-Ore., and Senator Sheldon Whitehouse, D-R.I., introduced the “Ending the Carried Interest Loophole Act” (S. 2617) (“bill”) aimed at completely ending the preferred tax treatment afforded to carried interest. The bill is designed to end both preferential capital gain tax treatment and the deferral of income recognition to the holders of a carried interest.

Chairman Wyden’s proposal intends to accomplish these goals by conceptually treating a carried interest like a borrowing of capital by the carried interest holder from the other investor-partners. As a result, carried interest holders would recognize on an annual current basis an amount of ordinary income essentially akin to the annual imputed forgone interest of such borrowing. The imputed interest deemed forgiven by the lender-partners becomes taxable income each year. The imputed-interest is calculated at a high rate. This amount of “deemed compensation” to the carried interest holder would be subject to ordinary income tax rates and self-employment taxes. 

An example provided in the news release accompanying the introduction of the bill shows the intent of the proposed legislation: “[I]f the fund manager receives a 20 percent carried interest in exchange for managing investors’ capital of USD 100 million, and the prescribed interest rate for the tax year is 14 percent, the fund manager would pay the top ordinary income tax rate of 40.8 percent tax on USD 2.8 million in deemed compensation.” The bill provides for an offsetting long-term capital loss in the amount of the deemed compensation, but such loss may or may not provide a tax benefit to a particular taxpayer in such year depending upon their specific situation.

It is critical to be aware that this proposal intends to cause compensation income every year to the carried interest holder. This is the case whether or not there has been a capital or other realization event by the partnership and corresponding distributable cash from an investment sale or disposition. In other words, this proposal creates annual phantom income to the holder of a carried interest. The bill is similar to a previous carried interest bill proposed by Chairman Wyden, but this proposal now has greater chance of passage given the recent shift in power to the Democrats and the instructions to the Finance committee to prepare its portion of USD 3.5 trillion reconciliation bill contemplated by the budget resolution passed by the Senate. As a result, the bill cannot be ignored. 

If you have any questions about this proposed legislation, please contact the Baker & McKenzie attorney with whom you usually work, or the authors of this client alert. This is an opportune and critical time to have an influence on the final outcome of any legislation regarding carried interest. If you would like to get involved in the legislative process, please contact Alexandra Minkovich of Baker McKenzie’s tax policy group (+1 202 452 7015, Alexandra.Minkovich@bakermckenzie.com) for further information on legislative opportunities.

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