On February 26, 2013, the House Ways & Means Committee Chair Dave Camp released a comprehensive tax reform proposal that would categorize private equity funds’ carried interest as ordinary income instead of capital gains. It contends that carried interest, the profit interest in the fund, is a partnership interest held in connection with the performance of a service and should be taxed as ordinary income, since private equity funds are in the active trade or business of developing and selling businesses.
By categorizing private equity funds as being in the business of selling businesses, this provision may also have secondary consequences in addition to taxing carried interest at the ordinary income rate, including subjecting private equity returns to unrelated business income tax (UBIT) or withholding taxes.
Proponents of the view that private equity funds are in the business of selling businesses reason that they do more than pump money into businesses that they purchase as they also have a huge role in developing and improving the management of these businesses. Hence, like any firm that develops property as part of its trade or business, their returns should be taxed as ordinary income. Opponents of this view believe that private equity funds are passive investors, not operators of the companies and should get to enjoy the lower capital gains tax rate. For a more in depth debate on this issue by Steven M. Rosenthal, visiting fellow at the Urban-Brookings Tax Policy Center, and Andrew W. Needham, a partner at Cravath, Swaine & Moore LLP, click here.
Additionally, the First Circuit recently weighed in on this issue, and the Supreme Court denied certiorari in Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. 2013) cert. denied, 13-648, 2014 WL 801176 (U.S. Mar. 3, 2014). In this case, two private equity funds asserted that “they are mere passive investors that had indirectly controlled and tried to turn around a struggling portfolio company.” Id. at 132. The First Circuit rejected their assertions, holding that private equity funds are engaged in a trade or business, reasoning that the funds’ activities, including those of its management company, exceeded those of a typical investor and were not merely “passive.”
In an uncertain time for private equity firms, it is imperative that they stay alert to their industry’s evolving tax environment as either development could have major consequences on the industry.