As discussed in Part 1 of our Tax Reform Update, two tax proposals have gained momentum in recent weeks. A short summary of President Obama’s 2015 budget can also be found in this post. The House Finance Committee Chair, Dave Camp, released his “Tax Reform Act of 2014,” aimed at reforming the current taxation of “carried interests.” Below is a short summary of his proposal, effective January 1, 2015, if enacted. Though no significant changes can be anticipated until after elections, both of these proposed reforms show tax change is likely coming in the near future.
Under Chairman Camp’s Proposal, an applicable partnership interest held in connection with the performance of services would be subject to a rule that characterizes a portion of any capital gains as ordinary income. An applicable partnership interest would include any interest transferred, directly or indirectly, to a partner in connection with the performance of services by the partner, provided that the partnership is engaged in a trade or business conducted on a regular, continuous and substantial basis consisting of the following:
(1) raising or returning capital,
(2) identifying, investing in, or disposing of other trades or businesses, and
(3) developing such trades or businesses.
This provision would not apply to a partnership engaged in a real property trade or business. The recharacterization amount would be determined (but not realized) on an annual basis and tracked over time. The result would be less capital gain characterized as ordinary income to the extent a service partner contributes capital to the partnership.
Any distribution or gain from the sale of a partnership interest (i.e., a realization event) would then be treated as ordinary to the extent of the partner’s recharacterization account balance for the tax year. Amounts in excess of the recharacterization account balance would be capital gain. The invested capital of a partnership is, as of any day, the total cumulative value determined at the time of contribution of all money and other property contributed to the partnership on or before such day.
Partner loans to the partnership and indebtedness entitled to share in the equity of the partnership would qualify as invested capital.
Furthermore, if at any time during a tax year a taxpayer holds directly or indirectly more than one applicable partnership interest in a single partnership interest, all interests in a partnership would be aggregated and treated as a single interest.
If you have questions regarding any of the above tax terms, anticipated changes, or this proposed reform, please contact Steve Dunavant, Senior Managing Director, at firstname.lastname@example.org or 901.685.5575.