Policy Issues
Taxation of Carried Interest

The Real Estate Roundtable and numerous real estate trade organizations oppose the carried interest tax. Changing the tax on carried interest would be a major change in tax law and belongs in a discussion about comprehensive tax reform where capital gains, partnerships and economic growth are the focus.

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Chart: Nearly Half of U.S. Partnerships are in Real Estate (from The Roundtable's 2014 Policy Agenda Tax Section)

   Real Estate Roundtable Position

    Background
        › Facts about Carried Interest
        › Enterprise Value

  Real Estate Partnerships and Carried Interest
        › Key Points & Partnership Structure
        › Carried Interest & Real Estate Partnerships: Q&A  


Position 
More than ever, commercial real estate is navigating through uncertain and unprecedented times. It is clear that the U.S. commercial real estate industry is trying to recover, but throughout most of the country, CRE is still struggling, representing a threat to the overall U.S. economic recovery. 

The commercial real estate industry agrees with the need to increase the federal debt ceiling and also with the efforts to reduce our country's long term budget deficits. However, The Real Estate Roundtable and other industry groups are concerned with proposals potentially changing the way that "carried interest" income is taxed. Do we want the U.S. economy to grow, or to shrink? If we want it to expand, elected officials cannot make growth investment less attractive. Such activity needs to be incentivized and rewarded, not punished.   

Some claim that dramatically changing the tax on “carried interest” is something that would only affect hedge fund managers.  In fact, the tax increase is squarely aimed at commercial real estate, since 46% of all partnerships in America are real estate and the vast majority of them use a carried interest structure. 

 • Carried interest has been used in the commercial real estate industry for several decades as an investment model for rewarding the general partner in a real estate business venture for taking on the risks and liabilities associated with real estate projects, such as environmental concerns, operational shortfalls, construction delays and loan guaranties. 

The proposal would effectively be retroactive with partnerships, including family partnerships and LLC’s, that may have been in existence for decades, losing the capital gains treatment on the carried interest, effectively devaluing all applicable existing properties. This scenario is exactly what happened after enactment of the Tax Reform Act of 1986, which subsequently caused a meltdown in commercial real estate and increased problems on banks.

By dramatically boosting the cost of capital, the carried interest proposal will discourage the risk taking required to start, grow, and save American companies and would substantially discourage investment in real estate assets across the country.

The commercial real estate industry is also deeply concerned about the impact this legislation will have on our communities. A tax increase on real estate partnerships will limit future economic development projects and slow the creation of desperately needed jobs. It is for this reason that the U.S. Conference of Mayors also opposes this tax increase on commercial real estate partnerships.  Increasing the tax on carried interest will hurt entrepreneurship, investment in communities and job creation in commercial real estate at a most inopportune time for our economy.  

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Real Estate Coalition News Release on Carried Interest (July 2011)

• This proposal also contains an enterprise value tax, which would deny those who build their businesses over many years long-term capital gains rates if the business is eventually sold in whole or in part.  Real estate investment partnerships would be the only form of business in America subject to this discriminatory treatment. Even policymakers who were aggressively pushing the carried interest proposal seemed to have recognized that the carried interest tax proposal is fundamentally flawed.  The question now is whether a new proposal will be drafted to address concerns about “enterprise value” and the negative effect on partnership law with respect to a wide range of entities, including family partnerships as well as companies that enter into joint venture partnerships.

We are pleased that the carried interest tax was not enacted in 2007 or 2009, and we urge Congress not to do so in 2013.  Taxing carried interest at ordinary income rates is not sound economic policy especially given the current economic crisis. Achieving tax fairness is complicated. Simple solutions often are not solutions at all.  Congress would be wise to fully examine this proposed "simple solution." 

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Background:

       Facts about Carried Interest

The proposed change to “carried interest” taxation is a serious tax law change for commercial real estate and if enacted, it could bring about the largest modification to the taxation of real estate in more than 20 years, since the Tax Reform Act of 1986.  Moreover, the change would come at perhaps the worst possible time as the industry and the economy continue to struggle to recover.

Real estate is a major part of the U.S. economy, and its tentacles are far-reaching.

 There are over 2.5 million partnerships, managing $13.6 trillion dollars in assets, and generating income of roughly $450 billion. 

 Real estate accounted for 45 percent or 1,125,000 of these partnerships and roughly $1 trillion in equity investment plus another $350 billion in debt financed investment.

 Real estate is a vital part of our national economy contributing, over $2.9 trillion or one third of the Gross Domestic Product.  Real estate asset values, residential and commercial, total nearly $20 trillion. 

1.) From an economic point of view: now is not the time to be raising taxes on real estate as this would hurt economic recovery and increase stress on community banks.

 The Congressional Oversight Panel Report warns that bank losses on commercial real estate loans could reach $300 billion, potentially wiping out "hundreds more community and midsize banks" and drying up the credit needed to restore the economy to health.   A “significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American.”

 The commercial real estate “debt crisis” in many ways is really an equity crisis. Conservative estimates reveal a vast “equity gap” well over $1 trillion; new equity capital is required to rebalance current leverage positions – fill the equity gap.

 Small businesses can’t borrow. While bigger companies can access the market for bonds and other debt, many smaller companies—which are key job generators—use the value of their own property to secure bank loans. As the value of those holdings has fallen, so too has their ability to get loans, crimping investment and hiring at a time when the recovery is gaining steam.

• Lower real-estate values translate into lower property taxes, crimping government spending. State and local governments employ 20 million police officers, teachers and other employees, roughly 15% of the work force and more than in all of manufacturing. But, 50%-70% of the money to provide services and pay employees comes from property taxes, which depend on property values.

2.) From a policy point of view: carried interest received at the partnership level is capital gain.

Risk of Loss: A general partner is at risk of losing more than just his or her initial cash investment because the general partner is the ultimate guarantor of the transaction. These risks assumed by the general partner manifest at a number of points throughout the development process:

 Assumption of project identification and pre-construction/rehabilitation expenses;

 Recourse construction/rehabilitation loan (the borrower is personally responsible for a portion of debt);

 Construction/rehabilitation cost overrun guarantees;

 Refinancing (to obtain permanent financing) risk;

 Environmental remediation.

Subordinated Return: The limited partners receive both a return of their initial investment and a priority return thereon before the general partner receives any carried interest. The general partner takes on the additional risk that any profit generated may only be sufficient to provide the priority return and a return of capital to the limited partners—leaving no carried interest for the general partner.  

 
          › Enterprise Value —  link to document  

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 Real Estate Partnerships and Carried Interest

    › Key Points and Partnership Struture

There are over 2.5 million partnerships, managing $13.6 trillion dollars in assets, and generating income of roughly $450 billion.

Real estate accounts for 46 percent of these partnerships and roughly $1.3 trillion in equity investment.

There are over 1.2 million real estate partnerships made up of 6.6 million partners.

Changing the tax treatment of carried interests would result in a tax increase of $13 billion annually, and $5 billion in real estate alone.

The economy-wide lost economic income from distorting taxes on real estate partnership capital would be $15 to $20 billion annually, and as much as 10 to 25 times greater once the detrimental impact on entrepreneurial talent is incorporated.

Workers would bear the impact of higher taxes in the form of reduced jobs in real estate and lower earnings overall.  

Real estate investment funds and many real estate ventures are organized as limited partnerships or limited liability companies (LLCs) under state law. [1] Investors become limited partners (LPs) in the partnerships and commit capital to the fund. A general partner (GP) manages the partnership in exchange for an annual management fee, often two percent of the fund’s committed capital, sometimes less.

The GP also receives a share of any profits; this profit-sharing right is often called the “promote,” “carry,” or “carried interest.” The GP typically receives twenty percent of the profits. The carried interest helps align the incentives of the GP with the goals of the LPs: because the GP can earn significant return on its interest if the fund performs well, the fund managers are driven to ensure the success of the partnership venture as a whole. The GP also contributes some of its own capital to the fund so that it has some “skin in the game.” This amount ranges from one to ten percent of the total amount in the fund.

After formation, the GP deploys the capital by investing in a portfolio of diversified properties designed to produce a certain risk/return profile. In the case of venture capital funds, the portfolio companies are start-ups the partnership believes will achieve success and can be sold for a large profit. In the case of private equity funds, the fund might buy out underperforming public companies, divisions of public companies, or privately-held businesses. Their investment goal is to sell of parts of the company for a profit and/or turn the company around under new management and eventually take it public. Hedge funds are investment vehicles, much like mutual funds, that invest in securities and use a combination of sophisticated investment strategies such as taking both long and short positions, using leverage, swaps and derivatives, and investing in many markets. They are limited by law, in most cases, to no more than 499 very high net worth investors.

After some period of time (often for real estate between five to 10 years) the fund sells its interest in the portfolio of properties or individual assets in the portfolio. The proceeds are then distributed to the partners, and when all the partnership’s investments have been exited, the fund itself liquidates.

The carried interest creates a powerful economic incentive for the GP. The GP is itself often a partnership or LLC with industry professionals as members. The GP receives a management fee that covers administrative overhead, diligence and operating costs, and pays the managers’ salaries. The management fee is fixed and does not depend on the performance of the fund. The carry, on the other hand, is performance-based.

The tax treatment of a fund manager’s compensation depends on the form in which it is received. There is no arbitrary conversion of income from ordinary income to capital gain. The GP is a partner in the fund and receives an allocable share of whatever the partnership’s income is – determined at the partnership level. 

The management fee, however, is not a partnership distribution. It is a partnership obligation in the classic “fee for service” context. Therefore, it is treated as ordinary income to the GP, taken into income as it is received on an annual or quarterly basis.

The treatment of a carried interest is more complicated. When a GP receives a profits interest in a partnership upon the formation of a fund, that receipt is treated as a taxable event.

However, because it’s difficult to pin down a fair market value at the time of grant, there usually is little or no tax owed. Section 83 of the Tax Code allows partners receiving a profits interest to opt to value the interest on receipt based on its liquidation value. Since the interest is not an interest in capital and only an interest in profits, if the partnership were to liquidate on the day the profits interest was granted, the interest would have no value since there would be no profits to distribute. Further, valuation is difficult because the partnership interest is typically non-transferable, highly speculative, and depends on the efforts of the partners themselves (and thus would have a lower value in the hands of an arms-length buyer).

In the context of corporate equity compensation, section 83 gives executives a choice: they may make a section 83(b) election and recognize income immediately on the current value of the property, or they can wait-and-see. If they make the election, any further gain or loss is capital gain or loss. If they wait-and-see, however, the character of the income is ordinary. From a revenue standpoint, the stakes of this choice are fairly low: any conversion or deferral of income, which lowers the executives’ tax bill, is roughly offset by the conversion or deferral of the corporate deduction for compensation paid.

The treatment of partnership equity is different than corporate equity. The tax law tackles the problem of partnership equity by dividing partnership interests into two categories: profits interests and capital interests.

A profits interest is an interest that gives the partner certain rights in the partnership (thus distinguishing it from an option to acquire a partnership interest) but has no current liquidation value.

A capital interest gives the partner certain voting rights in the partnership and also has a positive current liquidation value. When a partner receives a capital interest in a partnership in exchange for services, the partner has immediate taxable income on the value of the interest. Determining the proper treatment of a profits interest is more difficult, however. It lacks any liquidation value, making its value difficult to determine.

The tax treatment of a profits interest in a partnership has been fairly consistent historically. There was a brief period of uncertainty following the 1971 case of Diamond vs. Commissioner, where the Tax Court (affirmed by the Seventh Circuit) held that the receipt of a profits interest “with determinable market value” is taxable income. A profits interest in a partnership rarely has a determinable market value and it has become accepted that the receipt of a profits interest is not normally a taxable event. The IRS later provided a safe harbor, in Revenue Procedure 93-27, for most partnership profits interests.

The Treasury has proposed regulations (and an accompanying notice) that would reaffirm the status quo. The proposed regulations, like Rev. Proc. 93-27, require that, in order for the receipt of a profits interest to be treated as a non-taxable event, the partnership’s income stream cannot be substantially certain and predictable, that the partnership cannot be publicly traded, and that the interest cannot be disposed of within two years of receipt. The typical carried interest falls within the parameters of the proposed regulations. The interest has no current liquidation value; if the fund were liquidated immediately, all of the drawn-down capital would be returned to the LPs. And while the carried interest has value, it is not related to a “substantially certain and predictable stream of income from partnership assets.” On the contrary, the amount of carry is uncertain and unpredictable.

The receipt of a partnership profits interest, therefore, is not a taxable event under current law.

In the partnership context, characterizing a payment for services can be a difficult issue when the recipient, like the fund manager, is a partner in the partnership. Section 83 provides the general rule that property received in connection with the performance of services is income. Section 707 addresses payments from a partnership to a partner. So long as the payment is made to the partner in its capacity as a partner (and not as an employee) and is determined by reference to the income of the partnership (i.e. is not guaranteed), then the payment will be respected as a payout of a distributable share of partnership income rather than salary.

In sum, a profits interest in a partnership is treated more like a financial investment rather than payment for services rendered. Partnership profits are treated as a return on investment capital.  

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 Carried Interest and Real Estate Partnerships  

 › Questions & Answers 

President Obama's fiscal year 2011 budget proposal calls for legislation to tax "carried interest" as ordinary income. Although the proposal offers few specifics, if enacted in any form, the legislation could impose a tax increase on virtually all partnership structures used in all types and sizes of businesses. It would be especially bad for real estate. 

Resulting legislation could dramatically increase the tax on carried interest and treat such allocations as ordinary income rather than long-term capital gains.   
 See all answers to the following questions below:

1.) What type of ventures use partnerships with carried interest structures? 

2.) Why is a partnership structure used as opposed to a corporation or other entity? 

3.) Why is the flexibility to share partnership returns important?   

4.) Who are likely investors in real estate funds and do they support giving the general partner a carried interest? 

5.) What is the rationale behind the tax staff considered proposal to possibly require the taxation of carried interest returns at ordinary tax rates? 

6.) How does a carried interest differ from service income paid to a consultant? 

7.) Is there an economic distinction between a carried interest and a contingent profit fee? If not, why should there be different tax treatment? 

8.) Isn’t a carried interest intended as a way to defer tax on service income that should be recognized currently?   

9.) Why should a carried interest holder be taxed any differently than a corporate executive compensated on a performance basis? 

10.) Is a carried interest holder taxed differently than a corporate executive who receives compensation in the form of stock options that can be exercised in subsequent tax years? 

11.)Are general partner carried interests and corporate executive stock options comparable economically speaking?  

12.) What would be the impact on real estate if carried interest returns were taxable only at ordinary income rates?   

13.) How will re-characterizing carried interest returns as ordinary income affect tax complexity?   

14.) What impact will the effective date for the contemplated proposal have on transactions? 

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 1.)  What type of ventures use partnerships with carried interest structures?

Ventures large and small in all types of business areas use partnerships as their business entity of choice and include some form of carried interest incentive. This structure allows entrepreneurs to match their expertise and risk assumption with a financial partner and align the parties’ economic interests so that entrepreneurial risk taking is viable. The real estate industry employs partnerships with carried interests on projects ranging from small property development to large multi-billion dollar investment funds. Other industries using the same entity model include: oil and gas, cellular telephone, cable television, biotech, healthcare and restaurant.

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2.)  Why is a partnership structure used as opposed to a corporation or other entity?

A partnership is an entity used for investment ventures more than ongoing businesses. The timeframe for the venture usually is fairly limited and certain. It pre-supposes taking an investment idea from cradle to maturity then cashing in on the success of the venture. Real estate development, proving up of an oil well, discovering a new biotech technology are typically done through partnerships. The partnership allows the parties considerable flexibility in how they share the returns of the partnership over the life of the partnership. The return sharing ratio between the general and limited partners can, and often does, change several times throughout the life cycle of the partnership.

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3.)  Why is the flexibility to share partnership returns important?

Entrepreneurial ventures often entail taking on significant economic risk. In a typical entrepreneurial partnership you have an expertise partner, such as a real estate expert, who has an idea, experience, know how and some amount of risk investment. However, this partner does not have the capital to take on the contemplated venture. What is needed is a finance partner(s) to put up the capital. 

In typical real estate funds, finance partners put up eighty to ninety percent of the capital. Given that the finance partners have the most at risk, they want their risk capital returned as quickly as possible plus a return. The partnership is ideal in facilitating this because the partners can agree to pay all partnership income (in a real estate deal typically rental income) to the finance partners until their capital contribution, plus some negotiated return on investment, is paid. Thereafter, the partners can agree to share partnership income in any combination of ways they want to reflect the economics of the deal. When the partnership assets are sold, the carried interest kicks in, assuming agreed upon profit targets are met, and the proceeds are shared in accordance with that agreement.

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4.)  Who are likely investors in real estate funds and do they support giving the general partner a carried interest?

In many real estate funds, the finance partners are institutional investors, domestic and foreign, such as pension funds, endowments, charities and universities as well as high net worth individuals. Real estate investment is an alternative investment for these investors. It provides diversification and return potential needed to meet the investor’s goals. The success of the venture is critical to the investment being worth the investor’s while. Otherwise, they could simply invest in bonds and get a safe, but modest return. The end of the deal “upside” is the most desirable feature of the investment. Therefore, the investors very much want the general partner to have incentive to maximize the return. The carried interest provides this incentive and keeps the general partner “in the game” until the end. If the general partner received much of its return up front, it wouldn’t be motivated to see the deal through to its maximum fruition and the investor’s return would suffer.

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5.)  What is the rationale behind the tax staff considered proposal to possibly require the taxation of carried interest returns at ordinary tax rates?

There is no written proposal available regarding changing the taxation of carried interests. Tax staff members of the Senate Finance Committee have stated simply that they view the carried interest as compensation for services. Such compensation is taxed as ordinary income for other service providers; therefore, compensation for services received via a carried interest should be taxed similarly. The fact that the partnership pays the compensation in the form of a profits interest may not be compelling enough, to staff, to justify capital gain treatment. Staff is particularly focused on hedge fund managers.

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6.)  How does a carried interest differ from service income paid to a consultant?

Income derived from services is usually an amount certain, paid within the tax year (often contemporaneous with the provision of the services) and clearly acknowledged to be a fee as opposed to an investment interest. Sometimes, the income is incentive based (e.g. a bonus for exceeding a sales quota). While similar in this regard to a carried interest, it is paid in the same tax year the services are provided and, therefore, cannot be long-term capital gain. 

A carried interest is, first and foremost, an interest in the partnership. Its amount and timing depends on the success, or lack of success, of the partnership venture. Because it is a long-term, risk–based investment, it is not paid contemporaneously, nor is it guaranteed. Regardless of paper profits that might exist throughout the course of the investment, actual profit only exists when the asset is sold. 

The types of services a real estate general partner provides include: raising capital; identifying properties for acquisition or development, arranging financing; acquiring the properties, leasing and management of the properties; and selling the assets.

As an investor, the carried interest holder is exposed to all the risks of the underlying partnership investment. In the case of real estate partnerships, a carried interest often isn’t paid for 5, 7 or 10+ years when the partnership property ultimately is sold. To the extent the profits of the partnership reflect capital appreciation of the property; the carried interest is long-term capital gain.

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7.)  Is there an economic distinction between a carried interest and a contingent profit fee? If not, why should there be different tax treatment?

Both a contingent profit fee and a carried interest are both based on and derived from the profits of a venture. So, economically, there isn’t a distinction — a share of the profits is a share of the profits. However, state laws and the tax code allow ventures to be structured differently and these differing structures can result in different tax treatment. It’s not unusual and is a fundamental part of tax planning whether it be for corporations, partnerships, sole proprietorships or individuals.

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8.)  Isn’t a carried interest intended as a way to defer tax on service income that should be recognized currently?

No.  The general partner is compensated for its services partly through management fees, guaranteed payments and its share of the “split” of partnership income distributed prior to the carried interest performance hurdle being met. The general partner takes into income distributions equivalent to its carried interest in the year the carried interest is triggered by performance and paid.

Partnerships do not typically retain significant amounts of partnership income. Usually, the partnership agreement requires that the partnership distribute income to partners quarterly or annually unless there is a specific growth investment use of the proceeds identified or for capital maintenance of existing assets. So, when the general partner’s carried interest comes due, it is paid. It cannot be paid any sooner unless the partnership was to borrow against assets to advance the general partner its return. Such an eventuality would frustrate the sharing between the partners of the economic returns of the partnership. The risk burden would shift from equilibrium to the capital partners effectively reducing their return.

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9.)  Why should a carried interest holder be taxed any differently than a corporate executive compensated on a performance basis?

There is a valid comparison to be made between a general partner of a partnership and a corporate executive compensated based on the performance of his/her company. Both provide services designed to create a profitable enterprise and their compensation reflects their relative success. An important distinction, however, is that the corporate executive receives his or her compensation in the current year. It is not based on returns of an investment asset held more than 12 months. Therefore, it does not qualify as long-term capital gain eligible for the 15 percent capital gain tax rate. A real estate general partner’s carried interest, in the typical real estate fund, is paid almost entirely, if not entirely, out of long-term capital appreciation of the partnership properties.

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10.)  Is a carried interest holder taxed differently than a corporate executive who receives compensation in the form of stock options that can be exercised in subsequent tax years?

Yes, but not necessarily more advantageously. With few exceptions, an executive has no tax upon receipt of a nonqualified stock option. When an option is exercised, the executive pays the strike price and then pays tax at ordinary income rates on the bargain element of the option – that is the difference between the strike price (the price paid per share under the option) and the value of the stock on the day of purchase. If the stock appreciates above the bargain element, this gain is capital gain taxable at long or short term capital gain rates depending on whether the stock is held 12 months or more.

Therefore, after the taxable bargain element event, the executive becomes an investor in his/her company and receives tax treatment that applies to an investment in stock. Thus, dividends are taxed at a 15 percent tax rate as is long-term capital gain. 

The bargain element of a stock option is analogous to the value of a carried interest when granted to a general partner. Both values are taxable at ordinary rates. However, ascertaining the value of a carried interest upon receipt is speculative. Case law, rulings and regulations have addressed this issue and determined that in order to tax the carried interest on receipt, the partnership’s income stream must be substantially certain and predictable, the partnership must be publicly traded, or the interest can be disposed of within two years of receipt. A carried interest granted at the beginning of a partnership venture is not going to have a substantially certain and predictable income stream so no value can be determined on which to impose tax.

A liquidation value approach is also used as a measure. Since the profits interest is not an interest in capital and only an interest in profits, if the partnership were to liquidate on the day the profits interest was granted, the interest would have no value since there would be no profits to distribute. 

Like the executive who exercised his/her stock option, the carried interest holder is an investor and is taxed on his/her investment return. Noteworthy, however, is that in the case of a real estate carried interest, if rental income is received from the partnership, then the carried interest holder is taxed at ordinary income rates. The tax rate on depreciation recapture is 25 percent and the tax rate on long-term appreciation is 15 percent. Clearly, not as tax advantageous as a stockholder whose return is in the form of dividends and capital appreciation (15 percent tax rate).

It can best be summarized to say that there are tax tradeoffs between a stock option and a real estate carried interest. Each has their relative advantages and disadvantages. 

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11.)  Are general partner carried interests and corporate executive stock options comparable economically speaking?

In many ways, no.  When comparing corporate compensation through stock options to carried interests, the following should be considered: a) while most carried interests are subordinate to a preferred return, most options are not; b) while most general partners in most partnerships invest a significant part of their net worth in the partnership, most corporate executives do not; c) while most general partners “individually own” the infrastructure necessary to execute the strategy, most corporate executives do not because they are employees.  General partners own the infrastructure to own assets for themselves or in partnership with others and is why they are effectively contributing part of the value of their business to every partnership they sponsor; and d) while most corporate executives have contracts that give them “tax gross ups” on their options upon change of control (as employees), no general partner has this type of tax free treatment in any scenario on its carried interest.

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12.)  What would be the impact on real estate if carried interest returns were taxable only at ordinary income rates?

This is a broad sweeping question and the answer is as unique as the individual deal affected. However, there are some generalizations that apply. For smaller ventures, such as one off land development by a local developer, the effect could be significant as risk levels and capital requirements increase with the general partner’s reduced return. These types of entrepreneurs likely do not have the clout to pass the tax increase on to the investing partner. As a result, they may choose to sell the property rather than develop it if the after tax return isn’t worth the risk.

Larger, more experienced and sophisticated real estate entrepreneurs may have negotiating leverage to pass off this tax increase to the investing partners in various ways. In other words, re-price the deal. These ways include: requiring larger amounts of up front fees, lowering the preferred return amount, giving the general partner an earlier and/or increased share of partnership distributions, or increasing the carried interest percentage. Whatever the means, the investing partners (pension funds, endowments, charities) will get their investment return reduced. Lower after-tax returns mean fewer deals getting done, which will do collateral damage to investors, entrepreneurs and the workers employed in theses ventures.

Larger entrepreneurs also may seek to restructure their partnerships to avoid the tax consequences. This could involve the use of private REITs and restricted stock or nonrecourse loan arrangements from the partnership to the general partner to enable the general partner to purchase a capital interest. Whatever, method of re-structuring is chosen, the result would be a less efficient investment entity which would lead to lower investment returns and diminished capital flow to real estate. 

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13.)  How will re-characterizing carried interest returns as ordinary income affect tax complexity?

Partnership tax rules are already among the most complex rules in the tax code. The proposal being contemplated would add extraordinary complexity. Since we have not seen any specifics, we are left with many questions. For example, how do you treat the partnership gain that should be allocated to the general partner but isn’t because of the new rule? Does it get allocated to the limited partners? Will the GP’s share of capital gain simply be deemed ordinary income? Is the income service income or investment income? Staff believes the income is service income. If so, the partnership should be entitled a deduction for this amount which would flow through proportionately to all the partners – including the general partner who would offset his/her higher taxes with the deduction. What does the Treasury gain by such an offset? How does this, if at all, affect the certainty of valuing the profits interest upon receipt for Section 83 tax purposes?

Once a specific proposal is released, some of these questions may be answered but it’s a certainty that many, many other questions will be raised.

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14.)   What impact will the effective date for the contemplated proposal have on transactions?

f the contemplated proposal were to become law, its effective date could be made to apply to existing transactions or it could apply prospectively only to new transactions using a carried interest. If applied to existing transactions, a transition phase-in rule similar to the passive loss rules in 1986 would be appropriate. The passive loss limitation rules were applied to existing transactions but phased in 20 percent per year over five years.

If the rule were to apply to existing transactions and transition rules were not adequate, general partners would seek to avoid the additional tax burden. One way would be to try to renegotiate terms with the limited partners. Failing that, they might refuse to make future capital calls and terminate their funds. Depending on economic circumstances, they may sell fund assets or form a new fund and re-constitute the assets. 

The new fund would be structured differently. For example, the sharing of the partnership’s economics would be re-negotiated to compensate for the general partners new tax liability. Alternatively, the new fund could employ a new structure that avoids, or at least mitigates, the new tax liability on carried interests.

Smaller entrepreneurs that did not have the negotiating leverage or tax planning resources would bear the full brunt of the new liability. Thus, the heaviest burden of this new law would fall on them hurting small businesses and stifling entrepreneurship at the most important levels.

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[1] University of Colorado law professor Victor Fleisher wrote an article on carried interest taxation entitled Two and Twenty: Taxing Partnership Profits in Private Equity Funds.   He describes the partnership fund structure and the current taxation of a profits interest. This description is excerpted and modified to reflect real estate funds specifically.    

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