2015 Recap: All eyes on carry

Pfm revisits some of the best guest articles of 2015: Despite a Republican-controlled Congress now in session, GPs must still prepare for potential changes to carried interest taxation, wrote Hirschler Fleischer partner Brian Farmer.

Carried interest tax legislation likely won’t receive much attention in the new Congress, given its changed composition. But private equity managers and their investors may be overly optimistic to conclude that this proposal won’t rear its head again in the not too distant future.

At issue is the tax treatment of carried interest received by managers of private equity and similar funds (i.e. venture capital, real estate, natural resources, etc.). Carried interest – the share of a fund’s net profits received by managers of private funds – generally is taxed at capital gains rates. Some regard this treatment as a tax loophole. President Obama’s proposed 2015 budget would tax carried interest as ordinary income, which effectively would almost double its federal tax rate. With private equity assets managed by US-registered managers reported to be at a $7.4 trillion gross level as of the end of 2013, the magnitude of potential tax revenue from an increase in the effective tax rate on carried interest profits is likely too big of a target for Congress to ignore for long.

There also is at least the theoretical possibility that the tax treatment of carried interest could be changed by an executive order of the president. As a result, prudent private equity managers and their investors should continue to consider how one another should be treated in the event tax rates on carried interest were to increase.

When carried interest legislation was being discussed following the financial crisis, some private equity managers responded to this threat to their profits by adding language to fund partnership agreements that, in the event of an increase in the carried interest tax rate, would guarantee them the same after-tax carried interest dollars, at the expense of fund investors. Institutional investors in these funds, more often than not, pushed back at this language. As a result, the language in private equity limited partnership agreements regarding future carried interest legislation has become more nuanced and seemingly benign in the last several years.

For example, many private equity limited partnership agreements now allow the fund manager, in response to future carried interest tax legislation, to make unilateral amendments (i.e. without investor approval) in order to minimize the tax rate on the manager’s carried interest, but only if the fund investors’ aggregate distributions from the fund are not reduced as a result.

What this language doesn’t mention directly is that, while the aggregate distributions to investors may remain the same, the timing of the distributions could change. It is left to the manager’s discretion whether some or all of the investors’ distributions from the fund may be deferred in order to achieve a potentially favorable tax result for the manager. Recognizing the time value of money, deferred distributions result in lost opportunity for reinvestment or other use. Many institutional investors are clarifying in side letters and otherwise that neither aggregate distributions nor the timing of those distributions can be unilaterally changed by the fund manager to the detriment of investors in response to any future carried interest legislation.

For the near term, no news is good news with regard to carried interest legislation. In the interim, it is hoped that private equity fund managers and their investors can begin to arrive at a fair consensus on what impact any future carried interest legislation should have on each of them, both in terms of aggregate distributed dollars and timing of distributions.

Brian Farmer is chairman of Hirschler Fleischer's business section and leads the firm's Investment Management & Private Funds Practice Group.