Biden Admin has proposed taxing interest on profits as income
On March 28, 2022, the Biden administration proposed taxing “profits” or “carried” interest as ordinary income and imposing a self-employment tax on income and gains from such interest for certain partners in investment partnerships. The proposal is identical to the proposal made by the Administration last year.
Under current law, a “carried” or “profit” interest in a partnership received in exchange for services is generally not taxable when received and the recipient is taxed on his or her share of the partnership’s income. of persons depending on the nature of the income at the level of the partnership. Section 1061 requires certain deferred interest holders to satisfy a three-year holding period—rather than the normal one-year holding period—to qualify for the long-term capital gain rate.
Under the Biden administration’s proposal, a partner’s share of income on an “investment services partnership interest” (an “ISPI”) in an investment partnership would generally be taxed as ordinary income, and the gain on the sale of an ISPI would be taxable as ordinary income. income if the partner’s taxable income (from all sources) exceeds $400,000. The proposal suggests that income or gain attributable to goodwill or other non-service-related assets will not be taxed as ordinary income, and the Administration intends to develop mechanisms with Congress to determine how much of an ISPI’s income or gain should be recharacterized.
The Biden administration would define an ISPI as “a profit interest in an investment partnership held by a person who provides services to the partnership.” This definition is broader than Section 1061, which applies to partnership interests in the area of “raising or returning capital” and investing or developing “specified assets” ( generally limited to investment-type assets).
Under the Administration’s proposal, a partnership would be considered an “investment company” if substantially all of its assets are investment-type assets (which are similar to the definition of “specified assets” in the 1061), but only if more than 50% of the partnership’s contributed capital comes from partners for whom the interests constitute property not held in the course of a trade or business.
The purpose and meaning of the exception provided by this 50% test is unclear. Suppose insurance companies pay cash from their reserves to an investment partnership in exchange for partnership interest, and the general partner of that partnership receives deferred interest in exchange for managing partnership assets. The shares received by the insurance companies would appear as reserves held in the context of their commercial or commercial insurance activity. It appears that the General Partner would not be subject to the Administration’s Proposal or, as noted below, Section 1061, and therefore could receive long-term capital gain allowances on a period basis. one year detention.
Under the Administration’s proposal, if a partner who holds an ISPI also contributes “invested capital” (generally cash or other property, but not contributed capital attributable to the proceeds of any loan or advance made or guaranteed by a partner or the partnership or a related person) and holds a “qualifying capital interest” in the partnership, the income attributable to the invested capital, including the part of the gain recognized on the sale of an ISPI attributable to invested capital, would not be subject to reclassification.
“Qualifying equity participations” would generally require that (a) allocations from the partnership to invested capital be made in the same manner as allocations to other equity participations held by partners who do not hold ISPIs and (b) awards to such non-ISPI holders are material. The “same manner” requirement would be a return to the language used in the draft rule 1061, which was eventually relaxed to a “similar manner” requirement in the final rule. The proposal’s requirement that allocations to non-ISPI holders be “meaningful” is also a departure from the final rule in Section 1061, which examines whether capital contributed by “unrelated unrelated partners services” is significant.
The administration’s proposal would also require the partners to pay self-employment tax on ISPI earnings.
In addition, under an anti-abuse rule in the proposal, anyone above the income threshold who provides services to an entity (including entities other than partnerships) and holds a “disqualified interest in the entity would be subject to tax at the “rates applicable to ordinary income” on any income or gain received in respect of the interest.
A “disqualified interest” would be defined as a convertible or conditional debt, option or any derivative instrument relating to the entity (but does not include an interest in a partnership, shares in certain taxable corporations or shares in a S). Thus, under the proposal, if an employee received a ticket as compensation from a C corporation, any gain on the sale of the ticket would be taxable at ordinary income rates (but, apparently, would not be treated as ordinary income, so the gain could be offset by capital losses). The anti-abuse rule provides that the capital gain subject to it is taxable “at the rates applicable to ordinary income”, but does not provide that the capital gain is ordinary income. It is unclear why this rule is different from the rule that applies to ISPIs, but it would allow the taxpayer’s capital losses to offset capital gains.
The proposal notes that it is not intended to affect the eligibility of a REIT holding a profit interest in a real estate partnership.
The proposal would repeal section 1061 for taxpayers whose taxable income (from all sources) exceeds $400,000 and would be effective for tax years beginning after December 31, 2021. Taxpayers whose taxable income is $400,000 $ or less would be subject only to Section 1061. If the proposal were to become law, we expect fund promoters to be more likely to receive their compensation in the form of deferred charges rather than in the form of a deferred interest.
The administration’s proposal appears to be based on the Carried Interest Fairness Act of 2021, the House Bill of February 2021 (the “House Bill”) introduced by Bill Pascrell (NJ) and co-sponsored by Andy Levin (Michigan) and Katie Porter (California).
 The September 2021 House of Representatives version of the Build Back Better Act (the “BBBA”) would have extended the holding period to be eligible for long-term capital gains for interest carried from three to five years for holders with an adjusted gross income in excess of $400,000 per year. However, the proposal was not included in the October 2021 version of the BBBA (which did not contain any deferred interest proposal). For more information on the BBBA, read our previous blog post here.
© 2022 Proskauer Rose LLP. National Law Review, Volume XII, Number 143