The threat of legislation to charge ordinary income tax rates on a private fund manager’s carried interest has overshadowed the impact on fund managers of the Net Investment Income Tax (“NII tax”).
The NII tax is a new tax created by the 2010 Obamacare legislation, which only became effective 1 January 2013, and is imposed on so-called unearned investment income of high-earning individuals, at a rate of 3.8 percent. The tax will be significant for the managers of all but the smallest funds. For example, for a $500 million fund that generates a total of $100 million of carried interest, the NII tax will be $3.8 million, which is on top of any ordinary income or capital gains tax already imposed.
The NII tax applies differently to managers of private equity and real estate funds. Below is an overview of how the NII tax impacts the manager of each type of fund.
PRIVATE EQUITY FUNDS
For private equity fund managers, avoiding the NII tax on carried interest distributions requires both the manager’s “material participation” in the underlying portfolio business and the right ownership structure. If these two elements come together, a private equity fund manager may be able to avoid the NII tax on the all-important capital gains resulting from the ultimate sale of a portfolio company.
In order to avoid the NII tax on carried interest, the fund manager needs to be able to demonstrate regular, continuous and substantial involvement in the underlying portfolio business generating the income. Generally, the passive activity rules under federal tax law require an individual to spend at least 500 hours annually performing personal services in the business. In some situations, it may be possible to group multiple portfolio companies together as a single “appropriate economic unit” for purposes of meeting the annual hours test. Hours spent in direct management or operational activities at the portfolio business level count – monitoring, supervisory oversight and financial analysis at the fund level do not. For this reason, private equity fund managers taking minority ownership positions in portfolio businesses may have more difficulty in avoiding the NII tax than managers taking control positions and performing meaningful operational activities.
This analysis will need to be made for each individual owner of the fund manager entity based on his or her involvement in the fund’s portfolio businesses. Therefore, more senior personnel of the fund manager who are not involved in day-to-day management of portfolio businesses (because they are focused on fundraising or portfolio company dispositions) may pay more NII tax on their shares of carried interest than their more junior counterparts who are active in direct portfolio company management.
The optimal structure generally involves the portfolio business being organized as a limited liability company (LLC) or other pass-through entity for income tax purposes. This structure allows the fund manager and its owners to count their activity at the portfolio business level in determining whether the NII tax applies. In the case of a portfolio business that is organized as a taxable corporation, it may be possible to achieve a similar result by dropping the underlying business into an LLC owed by the corporation, with the fund equity invested in the taxable corporation while the carried interest is held through the LLC.
REAL ESTATE FUNDS
A real estate fund manager may be able to avoid the NII tax on carried interest to the extent the fund holds portfolio properties generating rental income, and the manager is considered a “real estate professional” that “materially participates” in the underlying real estate business under the passive activity rules. For purposes of the annual hour hurdles which define a “real estate professional” and “material participation,” the grouping rules for real estate investments generating rental income are generally more flexible than in the private equity context. However, services performed as an employee of the fund manager do not count unless the employee owns more than a 5 percent interest in the fund manager.
Real estate fund managers may have more difficulty avoiding the NII tax on properties they develop for resale or hold for investment purposes. Non rent-generating properties are subject to the more strict grouping rules that generally apply to private equity funds.
The NII tax represents nearly a 20 percent increase in the federal tax rate imposed on fund managers’ carried interest. However, there are important planning opportunities that private equity and real estate fund managers may be able to take advantage of to steer clear of or minimize this significant additional tax burden on fund managers.
Kevin Brandon is a tax partner with Richmond, Virginia-based law firm Hirschler Fleischer. Brian Farmer is managing partner of the firm’s investment management and private funds practice.