On July 29, 2010, from noon to 1 pm CST, some of my partners are offering a free webinar on recent legislative and regulatory developments with respect to tax and financial reform. Click here for more information about the webinar, including how to sign up to participate.
In numerous press releases over the last two weeks, both the House Ways and Means Committee and the Senate Finance Committee, along with their respective Chairs, Sander Levin and Max Baucus, have indicated a desire to pass as quickly as possible--but no later than May 31, 2010--a roughly $30 billion tax extenders package. As originally described, the tax extenders package was intended to address numerous areas, including individual tax relief, business tax relief, the extension of numerous expired energy incentives, disaster relief, community assistance, and a handful of miscellaneous provisions. Earlier this week, Rep. Levin announced that lawmakers are close to agreement on a provision that would phase in increased taxation on carried interests. Several of my colleagues in our tax group have prepared a memo discussing this aspect of the bill in more detail. Read it by clicking here. For more information, contact any of the attorneys whose contact information is provided at the end of the memo.
My colleague, Paul Comeaux, prepared the following brief Q&A about pending changes to the way "carried interest" is taxed. I thought it was worth sharing:
Q. What is the issue?
A. Congress is considering passing a law changing the way that “carried interests” are taxed.
Q. What is a “carried interest”?
A. A “carried interest” is the share of profits from a successful partnership that is paid to the partnership’s manager. It is money the manager gets not as a return on money invested, but rather based on the profitability of the partnership.
Q. Who is the main target of this potential change in the tax law?
A. Managers of hedge funds. Managers of hedge funds typically get paid a percentage of the profits that they earn for investors. (Usually 20%.) Right now, this profit generally is taxed at capital gains rates. The expected legislation would change this—profits paid to the managers will be taxed at ordinary income rates.
Q. Why do we care?
A. The change in tax law could hit real estate partnerships. For example, say Alfie wants to buy an old shopping center, lease it up, and sell it. He finds an investor who will put up the money—Alfie is bringing his real estate expertise, but no money. He tells the investor, “When we start making money, you’ll get your money back first, with a preferred return. Then, we split profits after that 50/50.” Right now, Alfie’s profit generally is taxed as capital gains. If the expected legislation passes, Alfie’s profits would be taxed as ordinary income.
Q. Can we see the current bill? Will real estate partnerships be carved out?
A. There is no final version of a bill to look at. This legislation will likely be added to the tax extender bill. Nobody knows if there will be carveouts or compromises for real estate transaction.
This proposal would be the largest tax increase on real estate since the 1986 Tax Reform Act.
Commercial real estate has been unfairly swept up in this carried interest campaign. We were not the intended target. It was introduced to curb the excesses and abuses of the hedge funds.
Unlike hedge fund and private equity firms, commercial real estate uses carried interest as the return for taking on the tremendous risks and liabilities associated with real estate development projects, such as environmental concerns, lawsuits, operational shortfalls, construction delays and loan guaranties.
If the carried interest provision is retroactive like the House version, the change in tax treatment would effectively devalue all existing properties that are held by partnerships. A sudden devaluation is exactly what happened in the Tax Reform Act of 1986, which caused the meltdown in commercial real estate shortly after that legislation took effect.
Hedge funds can move their investment vehicles off shore. Commercial real estate developers in your state can't move their investment off shore because real estate is local.
Today's BNA Daily Tax Report reported the Texas House's unanimous passage of a bill that would raise the small business exemption to the state franchise tax from $300,000 to $1 million (in annual revenue), effective January 2010. The bill has been sent to the state Senate for further action. One of the sponsors of House Bill 4765, state Representative William Callegari (R), released a statement in which he said, "The timing of the new margins tax on Texas business could not have been worse: tax bills came due right as the economy began to worsen. By raising the revenue exemption, small businesses will get some needed relief to help deal with the terrible aftershocks of the economic crisis." The franchise tax (Texas Tax Code Sec. 171) was revised in 2006 to include more businesses, with a goal of providing more funds for public schools. The tax is based on total revenues, not income. The text of H.B. 4765 can be seen at this link.