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* Article originally appeared on Private Equity International’s PE Manager website

The New Obamacare Tax:  Can a Private Fund Manager’s Carried Interest Escape Its Reach?*

The threat of legislation to charge ordinary income tax rates on a private fund manager’s carried interest has overshadowed the impact on fund managers of the Net Investment Income Tax (“NII tax”). The NII tax is a new tax created by the 2010 Obamacare legislation, which only became effective January 1, 2013, and is imposed on so-called unearned investment income of high-earning individuals, at a rate of 3.8%.  The tax will be significant for the managers of all but the smallest funds.  For example, for a $500 million fund that generates a total of $100 million of carried interest, the NII tax will be $3.8 million, which is on top of any ordinary income or capital gains tax already imposed.

The NII tax applies differently to managers of private equity and real estate funds.  Below is an overview of how the NII tax impacts the manager of each type of fund. 

Private Equity Funds.  For private equity fund managers, avoiding the NII tax on their carried interest requires both the manager’s “material participation” in the underlying portfolio business and the right ownership structure.  However, if these two elements come together, a private equity fund manager may be able to avoid the NII tax on the all-important capital gains resulting from the ultimate sale of a portfolio company. 

In order to avoid the NII tax on carried interest, the fund manager needs to be able to demonstrate regular, continuous and substantial involvement in the underlying portfolio business generating the income.  Generally, the passive activity rules under federal tax law require an individual to spend at least 500 hours annually performing personal services in the business.  In some situations, it may be possible to group multiple portfolio companies together for purposes of meeting the annual hours test, provided such businesses constitute an “appropriate economic unit,” a somewhat subjective facts and circumstances analysis prescribed by IRS regulations.  Hours spent in direct management or operational activities at the portfolio business level count--monitoring, supervisory oversight and financial analysis at the fund level do not.  For this reason, private equity fund managers taking minority ownership positions in portfolio businesses may have more difficulty in avoiding the NII tax than managers taking control positions and performing meaningful operational activities. 

This analysis will need to be made for each individual owner of the fund manager entity based on his or her involvement in the fund’s portfolio businesses.  The result of this case-by-case analysis may be that more senior personnel of the fund manager who are not involved in day-to-day management of portfolio businesses (because they are focused on fundraising or portfolio company dispositions) may pay more NII tax on their shares of carried interest than their more junior counterparts who are active in direct portfolio company management.

As mentioned above, fund structure is important in order to count activities towards meeting the requisite level of participation.  For this purpose, a preferred structure could utilize a limited liability company (LLC) or other pass-through entity for income tax purposes to hold each portfolio business.  This structure allows the owners of the fund manager entity (also typically a pass-through) to count their activity at the portfolio business level in determining whether the NII tax applies.  In the case of a portfolio business that is organized as a taxable corporation, it may be possible to achieve a similar result by dropping the underlying business into an LLC owed by the corporation, with the fund equity invested in the taxable corporation while the carried interest is held through the LLC. 

Real Estate Funds.  A real estate fund manager may be able to avoid the NII tax on carried interest to the extent the fund holds portfolio properties generating rental income, and the manager is considered a “real estate professional” that “materially participates” in the underlying real estate business under the passive activity rules.  For purposes of the annual hour hurdles which define a “real estate professional” and “material participation,” the grouping rules for real estate investments generating rental income allow an election to treat all rental real estate as one activity.  However, services performed as an employee of the fund manager do not count unless the employee owns more than a 5% interest in the fund manager. 

Real estate fund managers may have more difficulty avoiding the NII tax on properties they develop for resale or hold for investment purposes.  Non rent-generating properties are subject to the general grouping rules highlighted above as applicable to private equity funds.

Conclusion  The NII tax represents nearly a 20% increase in the federal tax rate imposed on fund manager carried interest.  However, there are important planning opportunities that private equity and real estate fund managers may be able to take advantage of to steer clear of or minimize this significant additional tax burden on fund managers.

By Kevin P. Brandon and S. Brian Farmer.  Mr. Farmer is Managing Partner of Hirschler Fleischer’s Investment Management & Private Funds Practice Group.  Hirschler Fleischer is a multi-specialty law firm based in Richmond, Virginia that serves the investment management industry among other areas of focus.  This article is for general informational purposes and should not be considered tax advice.

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