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Several Northeastern States Propose Legislation to Close the Carried Interest Tax Loophole


Synopsis
 
Similar to neighboring New Jersey (click here for our prior New Jersey alert) Connecticut, Massachusetts and New York have each proposed legislation that addresses the widely perceived “carried interest tax loophole.”
 
Issue
 
Alternative investment partnerships (private equity and hedge funds) are typically structured as limited partnerships. Under this structure, the general partner (GP) hires a separate management company entity (MC) to provide the management related services to the partnership. In return, the MC receives a management fee from the partnership, usually 2% of the assets under management.
 
Generally, the GP is also entitled to a share, typically 20%, of the future profits generated by the partnership. For private equity funds, this allocation of future profits is commonly known as the “carried interest.” For hedge funds, it is considered the “profits interest.”
 
Under current federal law, this 20% carry/profits interest may result in long-term capital gains as investments are disposed of, and realized for tax purposes. Long-term capital gains are subject to preferential tax rates, with the highest federal marginal rate on long-term capital gains being 20%.  Many argue that this carry/profits interest allocation should be considered compensation for services and, consequently, taxed as ordinary income. The highest federal marginal tax rate on ordinary income is currently 39.6%. 
 
Following New Jersey’s legislative proposal to eliminate this perceived inequity, Connecticut, Massachusetts, and New York’s proposed legislation would: 
 
  1. Change the character of the “carried/profits interest” to income earned from investment management services (all bills specifically use and define the term investment management services); and,
  2. Apply a surcharge on income derived from investment management services ranging from 19% to 24%.  
Each proposed bill ties its effective date to the enactment of similar legislation in all four states, i.e., Connecticut, Massachusetts, New Jersey and New York.
 
What Does CohnReznick Think?
 
Changing the character of the carried interest/profits interest to service income is likely to result in additional tax filings and taxes due for partners (both individual and corporate partners) of a private equity or hedge fund. We will continue to monitor these proposed bills and keep clients apprised of any new developments.
 
Contact
 
For more information, please contact Peter Rabinowitz, Director, State and Local Tax Services, at peter.rabinowitz@cohnreznick.com  or 646-625-5746; or Annie Yang, Manager, State and Local Tax Services, at annie.yang@cohnreznick.com or 646-601-7884.
 
 
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
 
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