Stephen Ehrenberg Stephen Ehrenberg

Taxation of carried interests

First Circuit decision could have a wide effect.

November 14, 2013
by Stephen Ehrenberg, CPA

Tax reform has been on the mind of corporate America throughout 2013, as taxpayers have sought to implement the changes brought about by the expiration of some of the Bush-era tax cuts, as well as the changes enacted in the Patient Protection and Affordable Care Act, P.L. 111-148. In the private-equity/hedge fund community, tax reform has focused the national spotlight on the taxation of carried interests.

Carried interests, benefits private-equity investment fund managers receive in the form of a profit percentage in a specific investment, have continued to receive scrutiny as taxing authorities attempt to close a perceived loophole in treating the amounts at issue as capital gain. In particular, a July 2013 ruling by the Court of Appeals for the First Circuit in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry & Pension Fund, No. 12-2312 (1st Cir. 7/24/13), could have a wide-ranging impact on the taxation of these items

What is a carried interest?

In the private-equity and hedge fund context, a carried interest is a compensation arrangement that represents a return on investment for the investment fund manager. Carried interests are typically earned based upon the following:

  • Private equity: In the private-equity world, carried interests are earned when the investment manager returns the capital initially contributed by the investors. Additionally, there may be a rate of return required on the investment that must be achieved before the carried interest is earned. These amounts are usually paid to investment managers upon a successful exit from the investment—the investment is usually held long term.
  • Hedge funds: Similar to the private-equity setting, a carried interest in the context of a hedge fund may have a required rate of return that must be met prior to the payout of any carried interest. However, whereas private-equity investments are generally long-term, hedge funds typically invest in more liquid investments, thus allowing for annual payments of carried interest benefits to investment funds and their respective managers.

Whereas management fees are paid to cover the operating costs of the investment, and thus are considered ordinary income, a carried interest represents the investment manager’s return on investment and thus the wealth accretion has generally been considered a capital gain.

Why the debate?

The tax treatment of carried interests has received attention from the taxing authorities since the mid-2000s, as the compensation earned by investment managers continued to increase as the size and magnitude of private-equity and hedge fund deals grew. The attention centers on the ordinary vs. capital gain treatment of the income earned on these types of earned interests.

The holding in Sun Capital has not only brought this issue to the forefront once again, but also expands upon the issues these payments raise. In that case, the First Circuit held that a private-equity fund that was involved with the failed restructuring of Sun Capital was not merely a passive investor. Rather, the court held that the Sun Capital private equity funds that were used in a buyout of a manufacturer were engaged in the manufacturer’s trade or business because they were “actively involved in the management and operation of the companies in which they invest,” and, as such, were liable for the manufacturer’s unfunded pension liabilities.

While Sun Capital was an ERISA case, it does not take much of leap for tax practitioners to see how it could affect the taxation of carried interests as well. In order to qualify for capital gains treatment of carried interests, private equity funds must not be engaged in the trade or business of operating the companies they invest in. If other courts were to adopt the Sun Capital court’s conclusion that private equity funds are not passive investment vehicles, but engaged in the trade or business of those companies, it could jeopardize that capital gain treatment by providing the government with a way around the carried interest rules.

If the courts adopt the Sun Capital approach, they would have to analyze the definition of a trade or business. Considering the numerous references to “trade or business” in the Code, as well as many issues raised by the correct treatment of the underlying items of income and expense, it is apparent that the issues central to this debate cross into a number of areas, including, but not limited to:

  • Definition of trade or business under Sec. 7701(a)(26).
  • Ordinary and necessary business expenses under Sec. 162(a).
  • Property used in a trade or business under Sec. 1231.
  • Capitalization vs. expensing.

No rush to judgment

If the First Circuit’s holding is applied elsewhere, the private-equity/hedge fund fields, as well as the tax community, would be greatly affected. Specific to carried interests, for instance, the trade or business ruling could require the payments to be treated as ordinary income, as opposed to the favorable capital gains treatment that most recipients have enjoyed since the beginning of these types of capital compensation.

However, the courts, along with the taxing authorities, have recognized that a change to the definition of “trade or business,” a cornerstone of the Code, would spark much debate across a wide array of industries and taxpayers. As such, while Sun Capital is significant, a seismic shift in the taxing and governing authorities’ definition does not appear on the near horizon, according to an attorney adviser in the Treasury Department. However, taxpayers, as well as the investment community, should continue to monitor the situation, as the implications could be significant.

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Stephen J. Ehrenberg, CPA, MST, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.