On December 9, 2009, the U.S. House of Representatives passed legislation that includes a provision that would tax as ordinary income any net income derived with respect to an “investment services partnership interest.” This carried interest provision in the Tax Extenders Act of 2009, H.R. 4213, would change the tax treatment of the performance allocation that, in years in which a hedge fund has positive investment performance, constitutes the bulk of a hedge fund manager’s revenue. Currently, most managers structure performance allocations so that all or most of such compensation is taxed as long-term capital gains at a rate of 15 percent. The carried interest provision would subject such compensation to tax at ordinary income rates, which for hedge fund managers generally would be at a marginal rate of approximately 35 percent. For more discussion of the Tax Extenders Act, see “Bills in Congress Pose the Most Credible Threat to Date to the Continued Tax Treatment of Hedge Fund Performance Allocations as Capital Gains
,” Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009). The Extenders Act also contains a provision that would effectively cause any publicly traded partnership (PTP) that derives significant income from investment advisory or asset management services to be treated, for tax purposes, as a corporation. This is because the provision would treat carried interest income as non-qualifying income for purposes of determining whether a PTP meets the 90 percent “good income” test. That test specifies that partnerships that (1) satisfy the 90 percent good income test (described in more detail in this article) and (2) are not registered under the Investment Company Act of 1940 will, in general, continue to be treated as partnerships and not as Subchapter C corporations for federal income tax purposes. This article examines the federal tax treatment of the carried interest received by hedge fund managers, as well as the tax treatment of PTPs. The article also outlines the likely effects of the Extenders Act on the tax treatment of both, and explains tax planning steps that hedge fund managers may take to avoid some of the adverse tax consequences of the bill.