No ordinary rumor

Last month, client memos from a pair of law firms warned that US law makers were examining carried interest as a potential source of new tax revenue. These new revenues, according to the thinking, would be generated by a reclassification of carried interest as ordinary income, which is taxed at a substantially higher rate than capital gains. Given the hefty role carry plays in a partner’s compensation, even the faintest whiff of such a large tax hike is going to command attention.
One of the memos, from the law firm Paul, Weiss, Rifkind, Wharton & Garrison, reported a number of tax proposals currently under review by the Senate Finance Committee. The memo stated: “Significant consideration is also being given to carried interest issues, with the focus on whether to characterize that income as compensation for services, and not as long-term capital gains.”
Long term capital gains are taxed at 15 percent, while tax on ordinary income goes as high as 35 percent. Supposing, for example, that a partner earned $3.6 million (€2.7 million)from carried interest one year, the tax bill would swell from $540,000 to $1.2 million if this tax change were to go through.
The memo goes on to warn that more proposals may be on the way concerning whether certain types of income should be viewed as capital gains or ordinary income. Word of the memos spread throughout the industry like wildfire, and one lawyer noted a third of his email one day was dedicated to the issue.
A similar client memo from the law firm Debevoise & Plimpton noted that also under congressional consideration are management fee deferrals, the mechanism whereby partners place their shares of management fee value into the fund capital account for long term appreciation. The Debevoise memo also stressed that the firm had no additional details concerning the proposals, and could not predict whether any would result in actual legislation.
One legal source offered more specific doubts concerning the rumors. The source noted, “It’s not very often that things get recharacterized.”
He explained that, in general, US tax law tends to treat taxable income according to the “underlying character” of the income. So, for example, when a partnership entity has realized a capital gain, the carried interest generated by that capital gain is characterized as a capital gain.
More at risk of being recharacterized may be the widely practiced technique of diverting the GP management fee into the fund. Policy makers may ultimately view the underlying character of this income as ordinary income, and tax it accordingly, regardless of whether it ultimately ends up as capital at risk in a partnership interest.
In any case, at this point the idea that Congress may revisit the taxation of carried interest remains just that: an idea. The only reports out on the subject note that the staff of one Senator—Chuck Grassley of Iowa—have included it on a list of ideas to generate tax revenue.
However, the legal source says, “This is something that people have worried about in general for a long time.” He adds, “When we structure funds, we structure them so that no IRS agent will say, ‘Wait a minute, what’s the difference between management fee and carried interest?’” That may prove of little value if the issue holds the attention of Senator Grassley.