On May 28, 2010, the House of Representatives passed the American Jobs and Closing Tax Loopholes Act of 2010 (the “Act”), which 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 most, if not all, of such income and gain as ordinary income. The legislation now moves to the Senate where it is expected to be taken up following the Memorial Day recess.

Under current law:

• An incentive allocation received by an investment fund manager (or general partner) from a private investment fund (i.e., a share of partnership income allocated by an investment fund that is treated as a partnership for tax purposes to an investment fund manager in its capacity as a partner of such partnership) retains the same character for federal income tax purposes as the income of the underlying investment fund. As a result, long-term capital gain and qualified dividend income allocated to an investment fund manager as an incentive allocation are taxable at long-term capital gain tax rates (currently, 15 percent for federal income tax purposes).¹
• An incentive allocation received by an investment fund manager from a private investment fund is generally not subject to federal self-employment tax.
• Gain derived by an investment fund manager from the disposition of an interest in a partnership engaged in providing investment management services may be treated as long-term capital gain eligible for preferential federal income tax rates.

Under the Act:

• A portion of an incentive allocation received by an investment fund manager would be treated as ordinary income (subject to a 35 percent federal income tax rate under current law), regardless of the character of the income of the underlying private investment fund. The portion of the incentive allocation subject to ordinary income treatment is subject to a phase-in. For taxable years beginning before January 1, 2013, 50 percent of an incentive allocation is treated as ordinary income and, for taxable years beginning on or after January 1, 2013, 75 percent of an incentive allocation is treated as ordinary income.
• Amounts treated as ordinary income under the Act would also be subject to federal self-employment tax.
• Under a unique application, gain derived on the sale of an interest in a general partner entity that is itself an “investment services partnership interest” could be treated as ordinary income in the proportions described above. 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.² 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 be taxed as ordinary income for federal income tax purposes. Such tax treatment does not exist for any other type of business in the United States.
• These provisions of the Act are effective for taxable years ending after December 31, 2010, effectively postponing their application to 2011. If a partnership taxable year includes December 31, 2010, 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, 2010.³

An “investment services partnership interest” is defined by the Act as any partnership interest held (directly or indirectly) by a person reasonably expected to provide a substantial quantity of investment management or advisory services with respect to assets held by the partnership. To the extent that an “investment services partnership interest” is a “qualified capital interest” and if certain other requirements are met, tax items allocated to a partner holding such “qualified capital interest” continue to retain the same character in the hands of the partner as in the hands of the partnership. For this purpose, the Act defines a “qualified capital interest” as that portion of a partner’s interest in the capital of the partnership that is attributable to the fair market value of any money or other property contributed to the partnership in exchange for such interest, adjusted for items of income, gain, deduction and loss taken into account with respect to such interest. However, an “investment services partnership interest” is not treated as a “qualified capital interest” to the extent acquired in connection with proceeds of any loan or advance made by any other partner or the partnership.

The Act includes an anti-abuse provision pursuant to which income and gain from certain interests (e.g., options, convertible debt) deemed to be the economic equivalent of an “investment services partnership interest” would also be treated as ordinary income in the proportions described above. An underpayment which is attributable to the application of this anti-abuse provision, or any anti-abuse regulation that may be promulgated by the Treasury Department under the authority granted to it under the Act, is subject to a 40 percent accuracy related penalty.

The Act now moves to the Senate for consideration. Many issues have been raised that could be addressed in amendments to the Act (or through the regulatory process), such as (i) the extent to which losses from one “investment services partnership interest” could offset gains from another such interest, (ii) how to determine whether a tax item is attributable to the period before or after the effective date of the Act, (iii) the determination of the amount of “qualified capital interest” with respect to the contribution of property having built-in gain or loss, (iv) with regard to the “qualified capital interest” exception, the implementation of the rule disqualifying a partnership interest acquired “in connection” with proceeds from certain loans, and (v) the lack of a mechanism by which an “investment services partnership interest” can cease to be treated as such upon the cessation of investment management or advisory services.

We will continue to monitor the progress of the Act and any modifications thereto. If you have any questions regarding this memorandum, 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).

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¹ Unless Congress takes action, qualified dividend income will no longer be federally taxed at 15 percent beginning with the 2011 taxable year.

² It would appear that the sale of an investment management company that receives only fee income pursuant to a contract and is not a partner in the investment fund would not be subject to these provisions and could produce capital gain rather than ordinary income.

³ Similar changes could also occur at the state and local levels, either where the state or locality piggy-backs federal tax law or where the state or locality feels compelled to adopt corresponding changes.