Hedge Fund "Carried Interests" Tax Controversy

By Tim Larason

A tax issue currently in the news is whether the favorable tax treatment of hedge fund "carried interests" should be ended and, if so, how.

In the oil patch a "carried interest" is a working interest in a well to be drilled free of costs up to a certain point. The carried interest may be a carry to bottom hole, carry to the tanks, or carry to payout. This is usually an interest retained by the previous owner as compensation for his property investment so valuation as taxable compensation is not an issue. Future income from the working interest will generally be taxed as depletable income, not capital gain.

Carried interests in the hedge fund industry are interests in an entity taxed as a partnership granted to the investment manager. Often these are 20% of net gains on sale of investments in addition to a 2% annual fee. These carried interests are carefully structured to qualify under IRS procedures as a "profits only" interest in the partnership free of immediate tax. The interest must be structured so that it is not a "capital interest," meaning it would receive nothing upon immediate liquidation of the partnership. If the partnership is newly formed, the cash investors would get their money back first. The holder of the carried interest then receives and reports the future income and capital gains as realized by the fund. The capital gains allocated to individuals usually qualify for a maximum federal rate of 20% (plus a likely investment income tax of 3.8%), much lower than the regular income tax maximum of 39.6%. The gain is free of self employment and FICA taxes.

The tax benefit to hedge fund managers has received almost universal criticism on the basis that the gains represent compensation for services and should be taxed as ordinary compensation income.

Many real estate investments and business startups also take advantage of the favorable rules for profits only interests. After the financial investors have recovered their investments, the developer or manager comes in a for a percentage share which, upon sale, may benefit from the capital gain rules.

Since only the hedge fund carried interests have come under criticism, most proposals to curb the benefit seek to focus only on hedge funds and continue the break for real estate and start up partnerships. Some even exempt part of the gain allocated to hedge fund managers. But these proposals would add to the complexity of the tax law so there is risk the profits only benefit could be ended completely.

However, any change will likely "grandfather" profits only interests in partnerships already formed. So where such an interest is desired, delay in documentation could result in loss of the favorable treatment.

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