Is the Carried Interest Loophole Closing?

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The infamous “carried interest” treatment enjoyed by hedge fund and venture capital fund managers may be at risk in the wake of the Tax’s Court’s decision in Dagres v. Commissioner, 136 T.C. No. 12 (March 28, 2011). Although the Tax Court didn’t directly assault the carried interest “loophole” in Dagres, some commentators think it may have opened the door for the Treasury and the IRS.

“Carried interest” is one part of a private fund manager’s payment for managing a fund. Most private fund managers receive two types of payment for their services. The first is a flat fee—usually 2% of fund assets. The second component, the manager’s carried interest, is a performance fee, which is typically 20% of the fund’s profits.

The income tax treatment of the 2% flat fee part is uncontroversial: It’s taxed as compensation for services at ordinary income rates and is subject to employment taxes. The carried interest component of the fee, however, is taxed at capital gains rates as an investment. As a result, what is often a majority of a hedge fund manager’s fee is taxed at the 15% capital gains rate instead of the more than double ordinary income top rate of 35%.

Classification of carried interest as “investment” is controversial. Many commentators believe that carried interest is more properly classified the same way as the 2% flat fee—as compensation for services that should be taxed at a top rate of 35%. They don’t see the manager’s interest in the fund as an investment since the manager doesn’t have to put any capital at risk to take the 20% profit.

The Dagres case brings the tax treatment of carried interests into question. Todd A. Dagres, a venture capital fund manager, gave a $5 million loan to a business associate. When payments on the loan stopped, Dagres took a substantial (greater than $3.5 million) bad-debt deduction.

The controversy arose because a bad-debt deduction is allowed only when it’s taken in relation to the taxpayer’s trade or business. At issue was whether Dagres’ management of venture capital funds was properly classified as a “trade or business” or whether he was an “investor.”

Between 1999 and 2003, Dagres netted more than $43 million in capital gains through his carried interest. He also received almost $10.9 million in salary as an employee. The IRS argued that the Dagres’ substantial capital gains income tended to show that he was an investor and was not engaged in a trade or business. The IRS argued that, as a result, he was not entitled to take the bad debt deduction.

The Tax Court disagreed, holding that “neither the contingent nature of… [Dagres’] profits interest nor its treatment as capital gain makes it any less compensation for services." The court compared Dagres role to that of a stockbroker who charges fees for investing other people’s money.

The problem for fund managers is that—although the Tax Court passed on the question of whether capital gains treatment is appropriate for a fund manager’s carried interest—it explicitly called the manager’s carried interest “compensation for services.”

Although that label doesn’t necessitate ordinary tax treatment, it could spark Treasury and IRS interest in reconsidering the carried interest question.

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See also The Law Professor's blog at AdvisorFYI.

 

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