Camp Draft Tax Reform Proposal Would Tax Carried Interests as Ordinary Income and Mark to Market Financial Derivatives
On February 26, the Chairman of the House Ways Means Committee, Dave Camp (R-Mich), released a draft Tax Reform proposal that would cut tax rates for both individuals and corporations and eliminate or modify many deductions and other tax expenditures. The proposal would set the maximum individual rate at 35% for individuals currently taxed at the 39.6% rate, and 25% for individuals who file jointly with income above $74,800 and below $464,200. The current 20% rate for most long-term capital gains and qualified dividends of individuals would be repealed but only 60% of such capital gains and qualified dividends would be subject to tax. The Alternative Minimum Tax would be repealed. Among the more significant proposed changes to deductions would be elimination of the deduction for state and local taxes and reduction of the principal cap for deductible home mortgage interest from $1 million to $500,000. Remaining itemized deductions, other than charitable contributions, would be deductible only at the 25% rate. Corporations would be taxed as a flat 25% rate beginning in 2019 (with the current 35% rate reduced two percentage points a year from 2015-2019).
Among numerous other changes, the Camp proposal generally would tax a significant portion of the carried interests earned by managers of investment funds and private equity funds as ordinary income instead of as capital gains. This rule would apply to distributions with respect to, and sales of, partnership interests that were issued, directly or indirectly, to a partner in connection with the performance of services by the partner in a partnership that is engaged in a trade or business of: (i) raising or returning capital, (ii) identifying, investing in, or disposing of other trades or business, and (iii) developing such trades or businesses. The proposal would not apply to a partnership engaged in a real property trade or business. Under the proposal, a service partner's share of the invested capital of the partnership treated as generating ordinary income to the partner would be determined by multiplying that share by a specified rate of return (the Federal long-term rate plus 10 percentage points), intended to approximate the compensation earned by the service partner for managing the capital of the partnership (the "Recharacterization Amount"). The Recharacterization Amount would be calculated annually but not taxable to the service partner until the service partner receives a distribution from the partnership or sells all or part of the partnership interest, with such distribution or gain treated as ordinary income to the extent of the service partner's cumulative Recharacterization Amount. Amounts of distributions or gain in excess of the partner's cumulative Recharacterization Amount and gains attributable to capital actually contributed to the partnership by the partner would be capital gain.
Another proposal would require taxpayers to "mark to market" financial derivatives at the end of each year, and any gains or losses from marking the derivative to market would be treated as ordinary income or loss. The proposal would apply generally to all derivatives, whether or not the derivative is publicly traded or references publicly traded securities. The proposal does not require stocks or bonds to be marked to market. However, if a taxpayer has a straddle of derivative and a non-derivative offsetting positions, then both the derivative and the non-derivative positions are required to be marked to market. Upon entering into such a straddle, the taxpayer must recognize any built-in gain (and defer any built-in loss) on the non-derivative. Transactions that are properly identified as hedges for tax purposes would not be subject to such tax treatment. Also excluded from the proposal would be derivatives on certain real estate held as inventory or for subdivision, and certain financing transactions such as securities lending, repos and similar financing transactions, as long as such transactions do not provide for payments determined by reference to stock, interests in partnership, notes and other evidences of indebtedness or commodities.
See: Statutory Text; Tax Reform Act of 2014 Discussion Draft Section-by-Section Summary; JCT Technical Explanation of Business Tax Reforms.See generally: Cabinet FATCA Materials (for Cabinet subscribers only).For more information please contact Daniel Mulcahy or Mark Howe.