Q. What is carried interest?
A. “Carried interest” refers to a profits interest in a partnership—that is, the person holding the interest receives a percentage share of the partnership’s profits. In most cases, a profits interest goes along with a capital interest—that is, a person invests capital and owns a share of the partnership and receives a proportionate share of the partnership’s earnings. Carried interest, a common form of compensation for managers of private equity funds, hedge funds, and similar investment vehicles, is a profits interest—typically, 2 percent—without an underlying capital investment. Compensation for services to a partnership via a profits interest (as opposed to a capital interest) has been recognized in partnership tax law for many years.
Q. Why has carried interest become an issue?
A. In hedge funds and private equity funds, carried interest is often used as a way to compensate the fund managers for the services they provide to the fund. Because the funds are organized as partnerships, the managers’ share of the earnings has the same character (i.e., is ordinary income or capital gains income, tax-exempt interest, or whatever), as it does for the partnership that earns it.
For many of these funds, a principal source of income is buying and selling the stock of other companies. Therefore, their earnings consist largely of capital gains, and the 2-percent-of-earnings going up to the fund managers is also capital gains in their hands.
The issue for many tax policymakers is that the fund managers are being compensated for their services, just like any worker who receives a salary. But instead of paying tax at ordinary income rates on their “salary,” they are paying the lower capital gains tax rate. Many people feel that this is unfair, especially since the fund managers earning carried interest often have very high incomes. They feel that fund managers should pay the same rate of tax on their compensation as other people.
The fund managers feel that they are receiving fair compensation for the risks they take in setting up the funds and making the investments. They feel that their knowledge and skill are a sort of “capital” that is invested in the fund and that is as valuable as a monetary contribution.
Q. How did this issue become associated with MLPs?
A. In 2007 two very large private equity funds decided to go public as MLPs, which entailed more public disclosure of their financial practices than they had to make as private entities. This brought the whole issue of carried interest to the attention of tax policymakers, some of whom reacted very strongly to the idea that fund managers were only being taxed at capital gains rates on their compensation. Because the issue became prominent due through the IPOs of two master limited partnerships, carried interest became associated with MLPs, as reflected in legislation introduced by Senators Baucus and Grassley in the 110th Congress to tax MLPs in the investment management business as corporations.
In fact, however, very few MLPs are investment management partnerships paying carried interest to their managers, and very few of the investment management partnerships paying carried interest to their managers are MLPs. Except for the few prominent exceptions, virtually all partnerships paying carried interest are nontraded partnerships. And taxing some MLPs as corporations does not get at the real issue, which is how carried interest paid by all partnerships should be taxed.
Q. What legislation has been proposed with regard to carried interest?
A. The main legislation that has been proposed would tax carried interest paid as compensation for investment management services as compensation for services, which means it would be subject to ordinary income tax rates. Legislation to do this was introduced in the 110th Congress by Reps. Charles Rangel (D-NY), then-Chairman of the House Ways and Means Committee, and Sander Levin (D-MI), a member of the Committee and the current Chairman. This very complex legislation established a definition of the type of partnership profits interest that is considered to be compensation for services—basically, a profits interest held by a taxpayer performing specified investment management activities for a partnership—and stated that all income received through this type of interest would be treated as compensation for services, taxed at ordinary income rates. Rep. Levin introduced a slightly modified version of the legislation in April 2009 as H.R. 1935.
This legislation, which is estimated to raise a good deal of revenue that could be used to offset tax cuts in other areas or to reduce the budget deficit, was passed by the House in the 110th Congress as an offset for alternative minimum tax relief, but was never adopted by the Senate. President Obama included the proposal in his budget for the next fiscal year. The legislation introduced by Rep. Levin in April was included as a revenue offset in another House bill, the Tax Extenders Act of 2009 (H.R. 4213), which was passed on December 9, 2009.
Q. How would this legislation affect MLPs?
A. The vast majority of MLPs that are outside the investment world would already be paying ordinary income to anyone holding a profits interest in them. These MLPs are not in the business of buying and selling companies, but in exploring for and producing oil and gas; gathering, refining, processing, and storing petroleum products; transporting these products in pipelines or on ships and barges; and other activities generating ordinary business income. For the most part, any capital gains they earn would be occasional and incidental, say from selling an asset, and would constitute a very small portion of their overall income in any year.
Q. Who would be earning a profits interest in these MLPs?
A. Most MLPs, except for the ones that are organized as limited liability companies, are limited partnerships whose capital comes primarily from their public shareholders and that are managed by a general partner (GP). The GP typically receives an incentive distribution right (IDR) under which the GP is allocated a percentage of total cash distributions that is higher with each incremental increase in the distributions. For instance, the MLP may start out with the shareholders receiving 98% of distributions and the GP 2%. Say distributions start at $1.00 a year. An IDR agreement might specify that when the distribution goes up to $1.25, the GP will get 15% and the shareholders 85% of the amount between $1.00 and $1.25, and that when it goes up to $1.50, the GP will get 25% of the amount between $1.25 and $1.50. IDR shares can go as high as 50%, although some MLPs have capped them at lower levels.
The IDR is a type of profits interest. If the activities that the GP undertakes in the process of managing the MLP fall within those outlined in the carried interest legislation, the IDR could be considered carried interest and taxed accordingly.
Q. Is this a problem for the GPs of MLPs?
A. In most cases, no—because, as noted earlier, the income that the MLP generates and passes through to them is already ordinary income and taxed accordingly. There is one group of GPs that could be affected, however: the nine that are publicly traded partnerships themselves. This is because the carried interest legislation would treat the IDRs as not only as ordinary income, but as a certain type of ordinary income: compensation for services. Recall that under the MLP rules of I.R.C. §7704, 90 percent of an MLP’s income must be one of several specified types—income from natural resource activities, real estate rents, etc.— in order for it to be taxed as a partnership. Compensation for services is not one of the specified types. And the activities that the legislation defines as investment management services include some that GPs may perform for the MLPs they manage.
Q. So would these publicly traded GPs have a problem if the carried interest legislation passes?
A. As the legislation is currently written, they should not. The current language of the carried interest bill states that for MLPs whose assets consist mainly of interests in other MLPs, income from a profits interest in those MLPs will continue to be qualifying income under section 7704 as long as it is ordinary income.
 There are a few PTPs earning “section 1231” capital gains from timber and similar resources.