How to keep your carried interest from the taxman

by Kimberley Weisul, contributor

(Fortune) -- Private equity fund managers are about to become much closer to their tax attorneys.

As one of a number of measures to help pay for the jobs bill, Congress is once again considering classifying so-called 'carried interest' -- the profits earned by managers of private equity firms, buyout firms, hedge firms, and venture capital firms -- as ordinary income, rather than as capital gains. That would boost the tax rate that individuals working for those firms pay on those profits to a maximum of 35% from 15%. Many real estate development partnerships would also be affected.

The investment management industry has an army of lobbyists fighting the bill. Accountants, meanwhile, are already trying to find ways around the legislation to keep those profits from Uncle Sam.

In this case, lawmakers seem to have anticipated this reaction. Tax attorneys and academics agree that the drafters of this legislation have baked in some solid anti-abuse measures designed to thwart the most obvious work-arounds. The language in the bill as it stands now is also quite broad, again in hopes of making the bill's provisions stick.

But let's face it, clever number-crunchers can come up with exceptions to almost any rule and the fund industry is bound to get creative should this bill pass. Expect some existing funds to reopen their negotiations with their limited partners in order to alter terms. And the most changes will happen as new funds are formed, says Adam Rosenzweig, associate professor at Washington University.

For the intrepid, here's a guide to getting the most out of your carried interest if the measure passes.

General Partners could invest more of their own cash.

The current legislation applies to partnerships that distribute profits disproportionately between partners. In many investment partnerships, the managing partners, known as general partners, receive a 2% management fee plus a 20% share of profits. They get that 20% even though they typically only contribute a single-digit percentage of the fund's capital. The more money they put in, the greater their chances of having their profits considered proportional.

Take the hit early.

Investment partnerships such as private equity and venture capital firms typically distribute profits after all their companies have been sold or have failed. But it doesn't have to be that way. "I've seen some people say, what we'll do is we'll take our hit early," says David Moldenhauer, a partner in the tax law group at law firm Clifford Chance. The general partners could distribute returns much earlier, while valuations are low, and pay taxes on them as ordinary income. They'd then hold those shares in their own private portfolios. The shares would generate capital gains taxes when sold. Moldenhauer says this may be a tough sell to limited partners. "The big ones are going to be very reluctant to give that type of discretion to a general partner."

Invest deal-by-deal.

Investment partnerships usually work through a fund, which pools the contributions of each partner for the life of the fund. But private equity and buyout firms could work on a deal-by-deal basis instead. The general partner could buy common stock in the firm's portfolio companies, and the limited partners could buy preferred stock. When the general partners sell their common stock, any profits would be treated as capital gains. Victor Fleischer, an associate professor of law at the University of Colorado, says some fund agreements already give the general partners some latitude to restructure the fund should tax law change. But in most cases, he expects the limited partners to resist this sort of change. Under the current system, the profitability of the fund is determined after the fate of all the portfolio companies is known. Working deal-by-deal, the general partners would get 20% of each profitable investment, rather than 20% of the fund's overall profits. "I'm pretty confident the limited partners will push back and not allow the economics to be screwed up simply to let general partners avoid paying their share of tax," says Fleischer.

Organize as a C Corp.

The proposed legislation does not apply to companies organized as C Corps. But unlike partnerships that would be affected by a new law, C Corps are subject to corporate level taxes. In a year when returns are bad, paying corporate tax may not be that much of a burden. Should returns recover, C Corps are unlikely to remain attractive.

Go offshore.

This isn't as easy as it sounds. Under the proposed legislation, the firm would have to organize as a foreign corporation in a country with 'a comprehensive' tax system, and a 'comprehensive' tax treaty with the U.S. It's possible the foreign taxes may not be much less than the U.S. ones.

Form a REIT.

It's possible that some real estate development companies could choose to organize as real estate investment trusts rather than as partnerships. But it's unclear if REITs would fall under the exemption for C Corps, and REITs can't be used for typical development-and-sale projects (such as converting a hotel to condos). To top of page