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10.16.2014

Carried interest legislation—in other words, legislation that would change the tax treatment of the “carried interest” received by the general partner (GP) of a private fund—has emerged over the last decade as an area of increasing interest to both GPs and institutional investors, prompting renewed consideration whenever Congress focuses on reform. 

The discussion regarding carried interest taxation has again captured headlines and the attention of the private fund community, triggered primarily by President Obama’s 2015 proposed budget, which calls for closing the carried interest “tax loophole” by treating a GP’s carried interest as ordinary income rather than capital gains (nearly a twofold increase in the federal tax rate).  While the debate over carried interest legislation is neither new nor settled, we have seen GPs continuing to pursue evolving strategies to anticipate and mitigate the potential effects of carried interest legislation on their bottom line.

Several years ago, we saw the first wave of GP responses to proposed carried interest legislation and the possibility of higher effective tax rates on carried interest.  For example, language was added that would allow the GP to unilaterally amend the fund’s partnership agreement to permit the GP to increase its carried interest distributions (and therefore decrease LP distributions) to preserve the after-tax amounts of carried interest the GP would have received but for the enactment of carried interest legislation.  Institutional LPs understandably objected to this attempt to pass off the risk of increased GP tax burdens, resulting in rewrites of fund documents and side letter provisions intended to protect LPs on this issue.

More recently, we have begun to see “gentler” language from GPs regarding carried interest legislation.  By way of example, a typical provision we encountered reads as follows:

“[F]ollowing passage by the U.S. Congress of U.S. federal income tax legislation that would have the effect of characterizing as ordinary income to the General Partner returns that under the law in effect as of the Initial Closing Date would be characterized as capital gain or qualified dividend income, the Partnership Agreement may be amended in such manner as determined by the General Partner in good faith to provide for a change in the terms applicable to the allocations or distributions of Partnership profits and losses to the General Partner to preserve the capital nature of such allocations or distributions under the law in effect as of the Initial Closing Date or otherwise to reduce the adverse impact of such change in law on the General Partner and its direct and indirect owners; provided, that any amendment made by the General Partner pursuant to this clause shall not reduce the aggregate amount of distributions to which the Limited Partners are otherwise entitled under this Agreement.”

From an LP perspective, one overlooked problem with this seemingly benign language involves the timing of distributions, which could be adversely impacted as a result of such an amendment.  That is, the provision above preserves an LP’s aggregate distributions.  It is left to the GP’s discretion whether amounts available for distribution (from a portfolio company disposition or otherwise) may be deferred by the GP in order to achieve a more favorable tax result for the GP.  While the priority return to which LPs are typically entitled—as well as a GP’s concerns about reputation and past performance numbers—protects LPs to a limited extent from erosion of their IRR in this situation, it does not entirely eliminate the problem. 

Accordingly, LPs might also wish to clarify in partnership agreements and/or side letters with GPs that the timing of distributions to LPs (in addition to the overall amount distributed to LPs) will not be negatively affected by any unilateral GP amendments to the fund documents motivated by carried interest legislation.  LPs would also be well advised to stay on the lookout for new variations on the carried interest legislation language in fund documents as the public debate over carried interest legislation continues.

Media Contact

Kristen M. Chatterton
804.771.5637
kchatterton@hirschlerlaw.com

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