UPDATE: Carried Interest. Inter-Partner Loans

As a follow-up to our recent post regarding the proposals to tax carried interest as ordinary income, there is a significant tax planning opportunity for service partners (partners actively providing services) who have inter-partner loans.  Our discussion covers President Obama’s American Jobs Act of 2011 and the bill introduced by Rep. Sander Levin (D-MI) on February 14, 2011.

Under both proposals, capital gain treatment remains in place for gains attributable to cash or property contributed by service partners in an “Investment Partnership” (more than 50% of the capital is contributed by passive investors).

The problem arises when the service partner’s capital contribution is provided by a loan (recourse or nonrecourse) made or guaranteed (directly or indirectly) by the partnership, another partner or a related party.  In these cases, any attributed gain from this capital contribution is taxed as ordinary income.

The planning opportunity to repay these loans or refinance them with a qualified loan is different under the two proposals.  Under the Obama bill, the loan needs to be repaid by January 1, 2013.  Under the Levin bill, the loan needs to be repaid by date of enactment of the legislation.

Three significant issues to be aware of:

  • The service partner’s capital contribution is tested (for capital gains treatment) only once, at the time of the original contribution.  So, if you have a disqualified loan now and it is not repaid by the respective dates, any attributed gain will be ordinary income, even if this loan is repaid/refinanced before the gain from this capital contribution is realized.
  • Any violation of these regulations will result in a 40% (as opposed to the usual 20%) tax penalty.   This penalty can only be avoided by attaching a disclosure to the service partner’s tax return of the tax position and detailing that the taxpayer is more likely than not to prevail on the merits.
  • There is a good chance that neither bill will be enacted in 2012, as it is an election year.  It seems likely, though, that there will be some change/compromise regarding the taxing of carried interest in 2013 or thereafter.

___________________________________________________________________________

IRS Circular 230 Disclosure

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.