STORM CLOUDS ON THE HORIZON: AN UNCERTAIN FUTURE FOR TAXATION OF CARRIED INTERESTS Panelist James Wreggelsworth Davis Wright Tremaine LLP

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Circular 230 Circular 230 – To comply with IRS rules, we must inform you that these materials were not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties that may be imposed under federal tax law or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein.

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 What is a Carried Interest? A carried interest (also known as a profits interest) is: An interest in a partnership (or LLC taxed as a partnership) Typically granted to a service provider who provides managerial or advisory services to or on behalf of the partnership Which, on the date of grant, would not entitle the holder to any share of liquidation proceeds if the partnerships assets were sold for fair market value, its liabilities repaid, and liquidating distributions made to its partners

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Why Use Carried Interests? Ability to avoid income recognition on receipt of a carried interest Allows service provider to share in appreciation in partnerships assets, generally at capital gains rates Used routinely in real estate and operating partnerships, not just in the hedge fund context

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Potential Drawbacks Self employment tax considerations Guaranteed payments for services Share of operating profits (other than real estate rental income) from trade or business activities Longstanding IRS position - a partner in a partnership cant also be treated as an employee Subjects service provider to estimated tax filing obligations Fringe benefits available for partners are less favorable than those available for employees

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Current State of the Law Rev. Proc , C.B. 343 Rev. Proc , C.B. 191 Proposed regulations under Sections 83 and 704 issued in 2003 Finalization on hold in light of pending carried interest legislation

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 House Passes H.R H.R. 4213, the Tax Extender Act of 2009, was passed by the House of Representatives on December 9, 2009 Senate is now considering tax extenders as part of a larger jobs bill If passed, would dramatically change the tax treatment of carried interests Follows similar carried interest legislation proposed in the past Included in President Obamas FY 2010 and 2011 budget proposals

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Legislative Objective According to the House Ways and Means Committee, the bill is intended to prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as a carried interest in an investment fund require them to treat carried interests as ordinary income received in exchange for the performance of services to the extent that the carried interest does not reflect a reasonable return on invested capital continue to tax carried interests at capital gains rates to the extent that the carried interest reflects a reasonable return on invested capital Actual scope is much broader Would fundamentally change the way most carried interests are taxed, including carried interests in real estate partnerships

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Scope of Carried Interest Legislation Applies only to an investment services partnership interest or ISPI ISPI is broadly defined to include any interest in a partnership, if it was reasonably expected, at the time the holder acquired the interest, that the holder or a related party would provide, directly or indirectly, a substantial quantity of specified services with respect to specified assets of the partnership

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Scope of Carried Interest Legislation What are the specified or tainted services? Providing advice regarding investing in, purchasing or selling specified assets Managing, acquiring, or disposing of specified assets Arranging financing with respect to acquiring specified assets Any activity in support of the above, including supervising or assisting others who perform the services

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Scope of Carried Interest Legislation What are the specified or tainted assets? Securities Real estate held for rental or investment Interests in partnerships Commodities Options or derivative contracts with respect to securities, real estate, partnership interests or commodities Look-through rule

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Recharacterization Rules Distributive share of net income with respect to an ISPI is treated as ordinary income, regardless of its character at the partnership level Distributive share of net loss with respect to an ISPI is treated as ordinary loss, but Allowed as a deduction only to extent of prior allocations of net income Disallowed net loss is carried over to future years No reduction in tax basis until the year in which the deduction is allowed

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Recharacterization Rules Gain realized on disposition of an ISPI must be recognized even if it would otherwise be deferred under a non-recognition provision of the Code Gain on disposition of an ISPI will be treated as ordinary income

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Recharacterization Rules If a partnership distributes appreciated property to the holder of an ISPI, gain that the partnership would have recognized on sale of the asset is treated as an increased distributive share to the holder, taxable as ordinary income Holder of the ISPI is treated as receiving a distribution of money to extent of the FMV of distributed property, resulting in gain recognition to the extent the deemed distribution of cash exceeds the holders tax basis in the partnership interest

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Recharacterization Rules An anti-abuse rule applies under certain circumstances where a person providing investment management services through a partnership participates in the appreciation in value of assets managed by the partnership through an entity other than the partnership. Example: A hedge fund manager performs investment management services for the fund. The manager holds stock in a Cayman Island corporation that is a partner in the fund, and the value of the stock (or dividends) is substantially related to the assets managed by the fund. Dividends and gain on sale of the stock are recharacterized as ordinary income.

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Qualified Capital Interest Exception Distributive share of net income or loss with respect to an ISPI is not recharacterized as ordinary to the extent attributable to a qualified capital interest Piggy-back rule applies if Partnership items are allocated to the service providers capital interest in the same manner as they are allocated to the interests of unrelated non-service providers, and Allocations made to the unrelated non-service providers are significant in comparison to the allocations made to the qualified capital interest of the service provider IRS and Treasury to provide guidance on proper allocations if the piggy-back rule is not satisfied

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Qualified Capital Interest Exception What is a qualified capital interest? Value of cash or property contributed to the partnership in exchange for the ISPI Any amount included in income upon receipt of the ISPI under Section 83 The aggregate net income allocated to the ISPI for tax years to which Section 710 applies Qualified capital interest is reduced by Partnership distributions The aggregate net loss allocated to the holder of the ISPI for tax years to which Section 710 applies

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Qualified Capital Interest Exception Special rules An ISPI is not treated as a qualified capital interest to the extent it is acquired by the service provider with proceeds of a loan made or guaranteed by any other partner or the partnership or by a person related to another partner or the partnership In testing significance of non-service partners qualified capital interests in relation to the qualified capital interest of a service provider, include amounts loaned or guaranteed by a non-service partner or a related party to the non- service partner in that partners qualified capital interest Purchaser of an ISPI in a taxable transaction succeeds to the transferors qualified capital account.

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Self-Employment Tax Considerations All amounts recharacterized as ordinary income or ordinary loss under Section 710 are taken into consideration in determining the self-employment tax liability of the holder of the ISPI (including amounts that would otherwise be treated as gain on sale of assets)

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Section 83 Considerations Recipient of a profits interest in consideration of the performance of services is deemed to have made a Section 83(b) election unless the recipient affirmatively elects otherwise Absent election to not have Section 83(b) election apply, recipient must take the excess, if any, of the FMV of the ISPI over its acquisition cost into income in the year in which the profits interest is issued Liquidation value is to be used for purposes of determining the FMV of a partnership interest received in connection with the performance of services

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Changes to Penalty Provisions Boosts accurately related penalty under Section 6662 from 20% to 40% for failure to comply with recharacterization rules under new Section 710 Makes reasonable cause exception to penalty more restrictive Requires adequate disclosure on return Requires substantial authority for position claimed Taxpayer must reasonably believe it is more likely than not that the position claimed is the proper treatment

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Publicly Traded Partnership Rules Income and gain recharacterized as ordinary income under new Section 710 is not considered qualifying income of a publicly traded partnership (PTP) If more than 10% of a PTPs gross income consists of non-qualifying income, the PTP will be treated as a corporation for federal income tax purposes. Transition rule for existing PTPs Special rule for certain partnerships owned by a publicly-traded REIT Special rule for PTPs that own interests in exchange-traded partnerships.

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Effective Dates Recharacterization rules would be effective for taxable years ending after December 31, 2009 Transition rule for partnerships whose taxable year straddles December 31, 2009 Changes to Section 83 rules would be effective on date of enactment Changes to publicly traded partnership rules would be effective for taxable years beginning after December 31, 2009 Changes to penalty rules would be effective for taxable years ending after December 31, 2009

James Wreggelsworth Partner, Davis Wright Tremaine LLP Presented February, 2010 Questions, Comments? James (Jim) Wreggelsworth Partner, Davis Wright Tremaine LLP direct fax