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Wyden’s Carried Interests Bill

On August 5, 2021, U.S. Senate Finance Committee Chair Ron Wyden (D-Ore.) and Senator Sheldon Whitehouse (D-R.I.) introduced legislation that, if enacted, would tax carried interest recipients annually at ordinary interest rates on “deemed compensation” that may exceed the carried interest recipients’ actual economic return. The bill, entitled “Ending the Carried Interest Loophole Act,” is substantially similar to one that Wyden proposed in 2019, but arguably has a greater likelihood of being enacted under the current administration.


Historically, carried interests have been a significant part of an investment professional’s compensation for providing services to hedge funds, private equity funds, or other investment partnerships. Carried interests are partnership interests issued in exchange for services that entitle the investment professional to some percentage (typically around 20%) of the partnership’s net profits after third-party investors in the partnership have realized a specified internal rate of return on their capital contributions.

Partnerships generally are not subject to an entity-level tax. Instead, each partner (including each carried interest holder) reports its allocable share of the partnership’s income, gains, losses, and deductions each year, whether or not distributed. Investment professionals typically are not taxed on the receipt or vesting of a carried interest. Moreover, because partnership items retain their character when allocated to partners, investment professionals in partnerships with buy-and-hold strategies (such as many private equity funds) historically have reported significant long-term capital gains, taxed at preferential rates, in respect of their carried interests.

Over the years, a number of politicians have lambasted the perceived inequity of according long-term capital gains to investment professionals in exchange for their services while taxing everyone else at ordinary rates on their salaries. Section 1061, enacted as part of the 2017 Tax Cuts and Jobs Act, was the Trump administration’s effort to close the “carried interest loophole.”

Overview of the Bill

Here are the most significant aspects of the bill:

  • Repeal of section 1061. The bill would repeal section 1061. As we have previously discussed, section 1061 imposes a three-year holding period as a precondition to recognizing long-term capital gains from allocations on, and dispositions of, carried interests issued to investment professionals (as opposed to the normal one-year holding period), and otherwise treats the capital gains as short-term capital gains. Section 1061 does not eliminate the ability of investment professionals to recognize long-term capital gains and does not tax them currently on unrealized appreciation.

The Biden Administration’s Fiscal Year 2022 Revenue Proposals (the “Greenbook”) would not repeal section 1061, but would tax investment professionals at ordinary rates on income from, and gains from the disposition of, their carried interests if their taxable income from all sources exceeds $400,000. Thus, under the Greenbook, section 1061 would be relevant only to investment professionals whose taxable income is below $400,000.

  • Applicable partnership interest. The bill applies only to applicable partnership interests (APIs), which are defined consistently with the same term in section 1061. Virtually all carried interests issued to investment professionals (either directly or through an aggregating entity, such as a fund’s general partner) would be APIs. In addition, the bill would treat as an API any partnership interest issued to a person that has received a loan from the partnership, another partner, or a person related to the partnership or other partner, unless the loan is fully recourse to the borrower and has an interest rate at least equal to a “specified rate,” which would have been 10.21% in June 2021. Unlike section 1061, the bill also treats partnership interests held by corporations as APIs.
  • Deemed compensation. Under the bill, a carried interest holder would include as ordinary income each year an amount equal to (1) the “specified rate” multiplied by (2) the excess of (a) the “applicable percentage” (which is the holder’s highest possible share of profits for the year, assuming all performance targets are met) of the weighted average capital invested by all partners as of certain measurement dates over (b) the weighted average capital invested by the holder as of those measurement dates. This deemed compensation would be subject to self-employment tax.

The theory underlying the deemed compensation inclusion is that the limited partners have made an interest-free loan to the carried interest holder in an amount equal to the excess of the weighted average capital that supports the holder’s highest share of profits over the holder’s own invested capital. The holder’s deemed compensation is the forgone interest on the loan, which the bill deems to be 9% plus the par yield for five-year High Quality Market corporate bonds for the first month of the calendar year with or within which the partnership’s tax year begins. The Detailed Summary accompanying the bill does not provide any meaningful rationale for the calculation of the deemed interest rate.

  • Long-term capital loss. Presumably to mitigate double-counting of income when the partnership sells assets at a gain and allocates part of the gain to a carried interest holder (or the carried interest holder sells its carried interest at a gain), the bill grants the carried interest holder an annual long-term capital loss in an amount equal to the holder’s deemed compensation. Long-term capital losses of individuals must be applied first to offset long-term capital gains, then short-term capital gains, then ordinary income only up to $3,000 annually. Any excess may be carried forward indefinitely. Accordingly, carried interest holders generally would not be able to use their long-term capital losses to reduce their deemed compensation (which is taxed as ordinary income).
  • Phantom income. The amount of a carried interest holder’s deemed compensation under the bill bears no relationship to the partnership’s actual performance. Accordingly, the bill could subject carried interest holders to tax on deemed income that they never earn economically, arguably stretching beyond its originally understood meaning the Sixteenth Amendment’s grant of congressional authority to tax “income.” Moreover, if the partnership does not earn substantial capital gains, or if Congress enacts Biden’s proposal to tax most carried interest allocations as ordinary income, then the carried interest holder’s long-term capital losses are effectively unusable unless the holder has capital gains from sources other than the partnership.

For example, assume that the limited partners contribute $100x and the investment professional contributes only services in exchange for a carried interest that entitles the investment professional to 20% of partnership profits after the limited partners have received a preferred return. Under the bill, the investment professional’s deemed compensation amount for the first year would be $2.04x, which is the 10.21% specified rate multiplied by the excess of (x) the 20% “applicable percentage” of the partners’ aggregate $100x invested capital over (y) the investment professional’s $0 invested capital. This is true regardless of the partnership’s target return; the bill makes the irrational assumption that the investment professional would have borrowed at 10.21% even to invest in a partnership that paid a lower return. And, if the partnership’s return consists substantially of interest, dividends, or other ordinary income, then the investment professional will be taxed on the income allocated to it in addition to the deemed compensation and will not be able to use its long-term capital losses to offset that income.

  • Disposition of carry. Under the bill, if an investment professional disposes of its carried interest within 10 years of the last date on which there was an increase in the investment professional’s applicable percentage, the investment professional must immediately recognize deemed compensation for the remainder of the 10-year period. The Detailed Summary accompanying the bill indicates that the amount of an investment professional’s deemed compensation for the disposition year is the amount of deemed compensation determined as if the disposition did not occur, plus the product of that amount and the number of taxable years remaining in the 10-year period. However, the bill’s language is unclear.
  • Tax on grant of carry. The bill would effectively codify Revenue Procedures 93-27 and 2001-43 by deeming investment professionals (in the absence of election otherwise) to have made a section 83(b) election to be taxed at ordinary income rates on the “liquidation value” of any carried interests granted to them. A carried interest’s liquidation value is the amount to which the holder would be entitled if, immediately after grant, the partnership sold all of its assets at fair market value and distributed the proceeds (net of liabilities) to its partners in complete liquidation. Normally, carried interests have zero liquidation value at grant.
  • Effective date. If enacted, the bill generally would apply to any taxable year of a partner that begins after the date of enactment and that includes any partnership taxable year that begins after the date of enactment. The amendments in respect of section 83(b) would apply to interests in partnerships transferred after the date of enactment.

Key Contacts

Adam Blakemore
T. +44 (0) 20 7170 8697

Linda Z. Swartz
T. +1 212 504 6062

Jon Brose
T. +1 212 504 6376

Andrew Carlon
T. +1 212 504 6378

Mark P. Howe
T. +1 202 862 2236

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