President Obama Proposes Taxing Carried Interest From Hedge Funds as Ordinary Income

President Obama recently announced a proposal to characterize income attributable to an investment manager’s carried interest (also referred to as an incentive allocation or performance fee) as ordinary income. The proposed re-characterization of carried interest income is part of the American Jobs Act of 2011, which the President submitted to Congress on September 12, 2011, and is a significant departure from the current treatment, which in many cases, allows an investment manager to treat carried interest income as long-term capital gain or dividend income, subject to a more favorable rate of 15%. The current proposal goes farther than previous attempts that would have treated only a portion of carried interest as ordinary income, because it would treat all relevant income as ordinary, excluding only partnership interests attributable to the manager’s invested capital that is reasonably allocated in the same manner as are made to partners who do not provide investment services.

The White House’s rationale for the proposal is that a carried interest from an investment partnership is attributable to the performance of services (including providing investment advice, managing, acquiring, or disposing of assets, arranging financing, or any activity in support of such services) with respect to securities, rental or investment real estate holdings, partnership interests, commodities, cash or cash equivalents, and options or derivative contracts held by the partnership. According to the White House, because such income is derived from the performance of services, the proposal would tax it as ordinary income and make it subject to self-employment tax. If enacted, the proposal would take effect for carried interest income earned for taxable years beginning after December 31, 2012, all of which would be characterized as ordinary income.

Because the proposal is clearly intended to target managers of hedge funds, private equity funds, real estate funds, and venture capital funds, many have argued that the proposal is punitive and discriminatory and point to the fact that the carried interest is an effective means of aligning a manager’s financial interest with that of investors, provides a powerful incentive to pursue the best investment opportunity and manage those investments effectively, and is essential to attract the most talented managers.

For additional information on the proposal and the substantial impact it would have on the investment industry, please contact Zac Rosenberg, Compliance Consultant by email at zachary.rosenberg@corecls.com or by phone at (619) 278-0020.