By Stephen M. Breitstone
In recent years, there has been much discourse about the perception that hedge fund and private equity fund managers can structure their compensation so they are taxed at capital gains rates on income derived from managing other people’s money. This is accomplished by granting the managers a share of profits in lieu of bigger investment management fees. This technique is normally carried out through investment entities structured as partnerships and limited liability companies taxed as partnerships. Assuming the underlying profit earned by the venture constitutes capital gain, the manager is taxable at capital gains rates on its share of profits.
The difference in tax rates can be as high as 20 percent under current law. Currently, capital gains rates are generally 15 percent, while ordinary income rates are as high as 35 percent. The realization that these investment managers are able to escape paying taxes at the normal rates applicable to compensation income has stirred a public outcry. Reform in this area is one of the key tax proposals included in President Obama’s budget.
However, it appears that there is already a mechanism in section 707(a)(2) to prevent compensation from being recast as a share of profits. This provision, enacted in 1984, has never been fully implemented because of a lack of regulatory guidance. As will be explained below, the proposed carried interest legislation would go considerably further than section 707(a)(2) by recasting virtually all profits earned by the managers, whether or not a substitution for fee or compensation income, as ordinary income…