By Daniel A. Kaminsky
In December, as part of H.R. 4213 “Tax Extenders Act of 2009”, the United States House of Representatives passed legislation that would tax partnership1 “carried interests” (also known as a “carry” or “promote” or “promoted interest”) as ordinary income instead of as capital gains, as they are now taxed. On March 10, 2010, the United States Senate followed suit and also passed its version of the Tax Extenders Act of 2009 (the “Act”), albeit with an amendment. As of the publishing of this article, it is not clear what effect if any the amendment will have on the taxation of carried interests. In addition, the Act is not yet in final form as the House and Senate may need to conference in order to reconcile any differences between the two versions. It is likely, however, that the Act’s passage will result in an increase in the tax rate on carried interests from the current capital gains rate of 15% to ordinary income rates as high as 35%. The carried interest portion of the legislation is retroactive and applicable to current structures with a carried interest element.
Essentially, the carried interest is a way partnerships divide the rewards of a project between the partners who provide capital and those who provide sweat equity. A carried interest is the right to receive a designated share of the profits of a partnership as compensation for managing or otherwise providing services to the partnership. It is often thought of as part of the compensation for the managers and is above and beyond any investments they may have in the partnership.
In real estate projects, a carried interest is often given to developers as a return for risk. For example, developers typically put up the risk capital in putting the deal together and often guarantee the debt of the partnership. One of the major incentives for developers to take on such risk is the carried interest; it allows developers to participate more fully in the upside of the real estate project.
Real estate developers and fund managers should keep these likely changes in mind as they prepare for the remainder of 2010 and beyond. For additional information, please contact Daniel A. Kaminsky at firstname.lastname@example.org or 414.225.1431 or your Davis & Kuelthau, s.c. attorney.
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1“Partnership” is used in this article to mean any entity treated as a partnership under applicable tax regulations. For example, depending on specific circumstances, a domestic limited liability company.