On September 12, the Obama Administration released proposed legislative language for the American Jobs Act (the “Act”), which was originally announced by the President in a nationally televised speech. Like several prior legislative proposals, the Act would effectively increase the federal income tax rate paid by investment fund managers on incentive allocations they receive from investment partnerships, as well as on gain from the disposition of such partnership interests (even if held for more than one year), by treating all such income and gain as ordinary income.

So far, Republicans in Congress have rejected the Administration’s call for higher taxes to pay for the spending provisions in the Act. Therefore, prospects for passage of the tax provisions contained in the Act are unclear at this time. It should be noted that similar language relating to the taxation of investment fund managers passed the House of Representatives when it was under Democratic control in 2010 but was never passed by the Senate.

Under the Act, the incentive allocation received by an investment fund manager would be treated as ordinary income (subject to a 35 percent tax rate under current law), regardless of the character of the income of the investment partnership. As under current law, an incentive allocation will only be subject to tax when the related income is realized by the investment partnership for federal income tax purposes.

In our view, a particularly controversial aspect of the Act is the treatment of gain realized on the sale of an “investment services partnership interest”¹ as ordinary income, which has been referred to as the “enterprise value tax”. Under current law, gain derived by an investment fund manager from the disposition of an interest in a partnership engaged in providing investment management services held for more than twelve months is generally treated as long-term capital gain eligible for preferential federal income tax rates. This is the same treatment accorded to the sale of an equity interest in every other business in the United States, even those that earn entirely ordinary income. However, under the Act, gain derived on the sale of an interest in a general partner entity that is itself an “investment services partnership interest” would be treated as ordinary income even if the interest is held longer than twelve months. This provision effectively taxes a portion of the gain attributable to the “enterprise value” of an investment management business as ordinary income rather than capital gain. The portion of the purchase price attributable to “sweat equity” or goodwill, or any other amounts not associated with capital contributed as a passive investment in the fund, would also be taxed as ordinary income. Such tax treatment does not currently exist for any other type of business in the United States.

These provisions of the Act would be effective for taxable years ending after December 31, 2012. If a partnership taxable year includes January 1, 2013, the amount of net income subject to the treatment described above is the lesser of (i) the net income for the entire partnership taxable year, or (ii) the net income determined by only taking into account tax items attributable to the portion of the partnership taxable year which is after December 31, 2012.² It should be noted that the legislation applies to carried interest which is realized for federal income tax purposes after the effective date. Therefore, an investment manager which has earned a carried interest attributable to unrealized gains occurring prior to the effective date of the Act will be subject to ordinary income treatment if such gains are realized for federal income tax purposes after the effective date.

If the changes in tax treatment described above are enacted, investment fund managers may wish to consider alternative structures which may ameliorate some of the effects of the enterprise value tax as well as the treatment of unrealized gains under the Act.

We will continue to monitor the progress of the Act and any modifications thereto and, in particular, the progress of the “enterprise value tax” and will update you regarding such progress as new developments occur. If you have any questions regarding this memorandum or issues relating to business transactions for investment managers, please contact Ronald P. Cima (212-574-1471), James C. Cofer (212-574-1688), Peter E. Pront (212-574-1221) or Daniel C. Murphy (212-574-1210) of the Tax Group or Jim Abbott (212-574-1226) or Craig Sklar (212-574-1386) of the Business Transactions Group.

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¹ Under the Act, an “investment services partnership interest” is a partnership interest (1) in a partnership substantially all of the asset of which are securities, real estate held for rental or investment, interests in partnerships, commodities, cash or cash equivalents and derivatives or options with respect to any of the foregoing assets (“specified assets”); (2) which is held or acquired in connection with the conduct of advising, managing, acquiring, disposing or arranging financing with respect to the acquisition of a specified asset, and (3) in a partnership more than half of the contributed capital of which is attributable to contributions of property by one or more persons in whose hands the partnership interests constitute an investment asset rather than a trade or business asset.

² Similar changes could also occur at the state and local levels, either where the state or locality adopts federal tax law as the basis of its tax system or where the state or locality feels compelled to adopt corresponding changes.