Shots Across the Bow: Tax Thoughts for Investment Fund Managers
While there are still many calls for and much talk about comprehensive tax reform, there are several important tax issues related to investments fund managers – both new and old – that may have a significant impact regardless of the status of tax reform.
Carried Interests Legislation. One of the lingering tax issues that is getting additional attention as of late is the taxation of carried interests. Senator Levin continues to be a strong proponent of taxing investment funds managers interest in investment partnerships as ordinary income rather than as capital gains. President Obama has similarly placed carried interest legislation in his 2014 proposed budget. While this legislation has been introduced before, with increasing calls for its passage, there is a real possibility that tax rates may increase to 39.6 percent for investment fund managers on their investment returns.
Management Fees Waivers. In a related development, the Internal Revenue Service is not waiting for Congress to enact carried interests legislation and has indicated that they are examining management fee waivers for investment fund managers. These waivers allow the managers to exchange their fixed management fee, which would be taxed at ordinary income tax rates, for a profits interest (a carried interests as described above) that would provide the manager with capital gains rates and a potential deferral of income. According to a recent statement made by a special counsel for the IRS, "there is a spectrum [of management fee waivers], and we're trying to figure out what's good and what's bad."
One issue that the IRS will likely be examining is the timing of the exchange of the management fee for a profits interest; if too much time elapses prior to waiver of the management fee in exchange for a profits interest, the IRS may challenge the timing and character of the income under the claim of right doctrine. Unlike the carried interests legislation for which little tax planning can be done, proper planning and structuring can help ensure investment fund managers are properly protected, especially at a time when the IRS has indicated they are taking a closer examination of the issue.
Sun Capital Ruling. Many have heard by now of the significant ruling that has come down from the First Circuit Court of Appeals in the Sun Capital Partners III, LP; Sun Capital Partners III QP, LP; Sun Capital Partners IV, LP v. New England Teamsters & Trucking Industry Pension Fund decision. The decision was significant because the Court ruled unanimously that two private equity funds were not passive investors in a business. Under what the court termed an "investment-plus" analysis, it determined that the funds were actively engaged in the business.
While this decision certainly has a potentially significant impact regarding liability protection going forward under Multiemployer Pension Plan Amendment Act of 1980 – a pension fund analysis that was central to the case at issue – this also generates many potential questions regarding the tax implications for funds going forward. While it remains to be seen how the IRS will handle this decision from a tax perspective, significant questions remain such as:
· Will the IRS use this decision as a mechanism to argue that funds are actively engaged in businesses, and thus should be subject to ordinary income rates in lieu of capital gain treatment?
· If the IRS alleges that funds are engaging in an active trade or businesses, would this result in self-employment tax liability on the returns of such investment?
· Finally, can tax-exempt entities continue investing in private funds because of the potential unrelated business income tax and tax-exemption concerns if the IRS alleges the funds are actively engaged in a business?
While the IRS has not yet provided guidance on these important questions, proper planning and structuring of funds can assist in dealing with the uncertainty.
This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.