The IRS has proposed rules reclassify how private equity executives’ management fees are taxed. Under the rules, firms will find it harder to convert their fees — which are taxed at high rates — into carried interest. Many don’t realize that this will have a large effect on the commercial real estate industry specifically investment structures.
The proposed amendment to the Internal Revenue Code would significantly increase the tax obligations of real estate fund managers and certain other fund professionals. In general, the amendment requires that income attributable to carried interest in a fund be treated as ordinary income (that is: employment-type income) regardless of the character or type of income at the fund level.
The underlying theory of the proposed amendment is that fund executives provide services and should be taxed as employees and eliminate the lower tax rates resulting from the “alchemy” of Wall Street that use a carried interest. Executives that have a share of the carried interest often recognize income at a capital gains rate (top rate of 20 percent) as opposed to ordinary income rates (top rate of 39.6 percent).
While people often think of the tax difference to be 39.6 percent and 20 percent, the actual difference will likely be greater because of special rates for qualified dividends and Medicare taxes. To better illustrate this, consider the following example:
Assume a real estate fund in which the general partner and its affiliates receive a 2 percent asset management fee and a carried interest that is equal to 20 percent of the profits distributed by the fund after the investors receive a specified preferred return. Under current law, the executive receiving a share of the asset management fee and the carried interest will be subject to: (i) ordinary income tax rate (top rate of 39.6 percent + Medicare and other taxes) on the asset management fee; and (ii) the tax rate applicable to the character at the fund level for the share of the carried interest, which in commercial real estate funds will almost always be capital gains (top rate of 20 percent).
The proposed amendment takes the position that all of the executive’s income is for services that will be taxed as ordinary income, effectively, the same way that employees are taxed on their salary and wages.
The amendment has many conforming changes so that an executive who receives carried interest (which is a partnership interest) and later sells the partnership interest will recognize the gain as ordinary or employment-type income and not capital gains.
What are the most significant concerns?
My primary concerns are the inconsistencies and imbalances that are created by the way this amendment seeks to increase tax revenue. The tax code has a certain balance that treats people uniformly. Partners are treated as co-owners of a business, and so each partner is treated as having their allocated share of the income, losses, gains and deductions of the partnership. Employees are treated receiving income while the employer recognizes a corresponding deduction.
The amendment disregards the fundamental distinction between a partner and an employee or contractor and adversely impacts the fundamental alignment of one of the most successful investment structures created by Wall Street.
The carried interest structure aligns the return or payment to the investment professional with the returns provided by the fund to the investors. It is a partnership in the true sense of the word; the investment professional only receives a return if the investor gets a larger return.
The amendment creates a disparity in the taxation of investment professionals based on the type of investments that they manage. The amendment treats a hedge fund manager or manager of commercial real estate differently from the manager of many other asset classes. This poses the question, what managers (asset classes) will be targeted next.
Specifically, how would sponsors and investors be affected?
The amendment will likely create a domino effect. The sponsors will have substantially less after-tax income from their endeavors. The tax code will now encourage sponsors to charge a larger asset management fee and a lower carried interest. If this occurs, then sponsors and investors will no longer have the same economic alignment as the traditional fund structure.
If sponsors will have a significantly lower after-tax return, they may require a greater allocation from the amount available to the investors and sponsors, which will lower investor returns.
Lower investor returns will require more cash flow and capital gains from the investors, which may result in:
a) Adverse impact to CRE property values (purchase prices)
b) CRE sponsors will further leverage CRE to get a better return on equity (which will provide greater risk to CRE projects, especially development deals)
c) CRE sponsors will chase returns and accept greater risk
d) CRE sponsor compensation will move to asset management fees that are paid regardless of the investment returns; more cash compensation and less equity-based compensation will lower the cash available to the fund to deploy in investments
e) Lower investor returns may provide less capital to deploy in the CRE asset class
It is important to note that the amendment does not encourage greater investment or efficiencies (for example, more use of energy efficient building products). As such, this is a zero-sum game – the amount of cash flow and capital gains from hedge funds and commercial real estate projects is not impacted by the amendment. The only consequence is the amount of cash or profit allocated among sponsors and the investors.
How would REITs be impacted?
This is the one part of commercial real estate that may not be adversely impacted – at least for now. However, the amendment will affect the partnerships in any “Up REIT” and “Down REIT” structure.
The traditional incentive stock option plan and related equity-based compensation structures for corporations will continue to be an efficient way to align investor return and investment professional compensation. It remains to be seen if this will be viewed as a loophole that is similarly targeted for reform.
Could CRE investment be jeopardized, and in what way?
CRE will likely be subject to a domino effect that could result in substantial economic pressures that lower CRE values. Sponsors may further leverage CRE projects or invest in projects with a greater risk profile to get more returns to compensation for the higher tax rate.
Are there alternative proposals available that might be more palatable?
There are few alternatives. This is a political issue as well as an income tax issue. The thought process underlying the amendment is that certain well-compensated investment professionals should be required to pay more into the system (government). If this was the only issue addressed, then the amendment would likely tweak the net investment income tax under the Affordable Care Act Tax.
The alternative is to have a meaningful discussion regarding the populist argument regarding the income disparity with respect to certain investment professionals.
How are they structured?
The structure is not in the tax code but in the political process. In order to structure a meaningful discussion, there should be better and clearer communication. CRE sponsors should show their alignment to investors, including pension funds and other institutions and note the amount of their compensation to the returns provided to investors.
Hedge fund and CRE professionals need to show the same treatment as other professionals. A CEO that receives equity-based compensation will recognize capital gains for increasing the stock price. Why should a CRE sponsor receive ordinary income for increasing and delivering cash to investors resulting from increased property values?
Is there a backlash to this plan, and who is leading it?
Representative Paul Ryan — the House Ways and Means Committee Chairman — has said that this proposal is off the table until 2017. In the meantime, other hedge fund and CRE professionals are likely to voice concerns and counter-arguments.
What happens next?
This tax proposal has resurfaced a number of times and will likely be a “wedge issue” in the upcoming presidential and congressional campaigns. It will be interesting to see how this issue is presented from a communications perspective. In short, CRE sponsors will be in the political spotlight and required to justify their compensation model. The interesting question about the proposed amendment will be if there will be a meaningful discussion on tax fairness and equality or if it’s just about political posturing. The issue should not be limited to investment professionals. It is really whether equity-based compensation should receive capital gains treatment under the tax code. We have had that discussion in the U.S. tax code and decided that there are many benefits to the individual and the employer or investor.
Richard Morris is a corporate partner at Herrick, Feinstein L.L.P. His practice focuses on a variety of private fund and capital market transactions. Morris has practiced law for 25 years after eight years as a ‘Wall Street’ CPA, first as a regulatory auditor.