Tiered partnerships: will net investment income tax and proposals to change taxation of carried interests wreak havoc?

• Author: Etienne, Corinne

Tiered partnerships are popular investment vehicles that generally allow for a good deal of flexibility, which is in and of itself a fully nontax consideration. Further, certain tax benefits add to the structure's attractiveness, such as a single layer of tax and favorable capital gains treatment for capital transactions. However, as part of the Obama administration's tax reform agenda, these structures could be subject to ordinary income tax treatment on many forms of revenue that had previously enjoyed a lower capital gain tax rate.

First, as part of the Patient Protection and Affordable Care Act (PPACA);, P.L. 111-148 (as amended by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152), the net investment income tax was created (new Sec. 1411) effective Jan. 1, 2013. The tax rate is 3.8%, and the proposed regulations (REG-130507-11) cast a very large net, capturing most forms of income. Most multitier partnership investments appear to be sheltered from the net investment income tax as long as the activity is not "passive." However, for those involved in trading in financial instruments or commodities, these activities appear to be subject to the net investment income tax, regardless of whether that activity is active or passive for the taxpayer.

Second, proposed changes to the tax treatment of carried interests are still being debated as part of overall tax reform. Several similar proposals have been made in recent years. They generally would treat all "carried interest" income related to an investment services partnership interest (ISPI) as ordinary income, including any gain derived from the sale of the interest (see the American Jobs Act of 2011, H.R. 12, S. 1549; the American Jobs and Closing Tax Loopholes Act of 2010, H.R. 4213; H.R. 1935 (2009); and Levun, "Planning Considerations in Anticipation of the Potential Carried Interest Legislation," Partnership Tax Watch Newsletter (October 2010)). These rules rely on several new concepts, one of which is the "specified asset." The issue with multitier partnership structures is that a partnership interest, for purposes of the carried interest proposals, would itself be considered a specified asset. This broad definition of a specified asset would insert an ISPI in many multitier partnership structures involved in businesses not originally targeted by the proposals. In these structures, any carried interest income would suddenly become subject to ordinary income tax...