Obama Administration, Treasury Propose to Increase Taxes on Private Equity and Venture Capital Fund Managers

In the aftermath of the capital market, credit market and banking crises that have gripped the U.S. economy, President Obama and his administration have called for broad reforms of the American financial system.  To that end, the United States Department of the Treasury released the General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (the “Tax Proposals”) on May 11, 2009.  The Tax Proposals contain, among other things, the following provisions that, if enacted, could have a considerable impact on venture capital and private equity funds as well as their managers and investors:

• Carried interests in private equity partnerships currently are taxed on a “pass-through” basis—a fund sponsor generally is taxed in the same manner as the other investors on any partnership income or gain allocated to the sponsor’s carried interest.  Where a partnership has long-term capital gain, capital gains treatment would be available to the sponsor.  Gain from the sale of a carried interest generally would be characterized as capital gain (except to the extent attributable to inventory or unrealized receivables of the partnership).  The Tax Proposals generally follow the approach of recent legislative proposals concerning the taxation of carried interests (including legislation sponsored by Senator Sander Levin, H.R. 1935, reintroduced on April 2, 2009), and would treat income attributable to a “service partnership interest” as ordinary income.  A “service partnership interest” is broadly defined as a carried interest held by a service partner.  Carried interest income (including gain recognized from the sale of a carried interest), therefore, generally would be treated as ordinary income irrespective of its character at the partnership level.  Additionally, carried interest income generally would be subject to self-employment taxes, and therefore, a service partner would be responsible for paying the Social Security and Medicare tax. 
• The Tax Proposals would not apply to income attributable to a service partner’s “invested capital”, which would be eligible for capital gain treatment.  Specifically, this exemption applies to the extent that a partner contributes money or other property (“invested capital”) to the partnership, and there is a “reasonable” allocation of income and loss with respect to such partner’s invested capital.  The exemption would not apply where a partner’s contribution of money or other property is financed by a loan or other advances made or guaranteed by the partnership.
• Coupled with the foregoing, the Tax Proposals also contemplate replacing the current 33% and 35% tax brackets for individuals with income over $250,000 ($200,000 for single filers) with tax brackets of 36% and 39.6% as well as increasing the tax rate on capital gains and dividends for these individuals from the current rate of 15% to 20%.
• Additionally, the Tax Proposals include an “anti-abuse” rule intended to prevent the avoidance of the proposed carried interest tax treatment through the use of certain non-partnership compensatory arrangements.  Under this rule, holders of a “disqualified interest”—which includes a convertible or contingent debt instrument, an option or any derivative interest with respect to the partnership—would be subject to ordinary income tax treatment.
• The Tax Proposals would apply to tax years beginning after 2010.

In light of the Obama administration’s announcement that it intends to “re-regulate the way U.S. financial markets work,” Troutman Sanders LLP’s Reregulation of Banking and Financial Services Team will continue to actively monitor any future developments and provide periodic updates with respect to the Tax Proposals that affect private equity and venture capital funds.

CONTACT

Mark Goldsmith
Tax Partner
212.704.6255

John Owen Gwathmey
804.697.1225