Proposed “Carried Interest” Legislation Applies to LTIPs

It appears increasingly likely that Congress will pass “carried interest” legislation as a revenue raiser to pay for the extension of certain other tax breaks.  As proposed, the legislation would generally treat the incentive allocations received by sponsors of investment funds organized as partnerships and LLCs as ordinary income (rather than as capital gain, which is generally the case under current law).  More specifically, the most current version of the legislation would treat 75% of the incentive allocation as ordinary income, but allow 25% to continue to be taxed as capital gain, for 2013 and thereafter.  With respect to 2010, 2011 and 2012, it appears that 50% of the incentive allocation would be treated as capital gain and 50% as ordinary income.

The most current version of the legislation also generally would apply to LTIPs issued by an UpREIT (i.e., operating partnership units granted under equity incentive programs that are structured as “profits interests” for federal income tax purposes) and does not contain an exemption for LTIPs issued prior to the date of enactment.  The proposed legislation, however, does not appear to apply to taxable dispositions of profits interests prior to the date of enactment.  Therefore, holders of vested LTIPs that have been booked up to “parity” with common operating partnership units and are eligible for conversion/redemption should consider the choices with respect to their LTIPs that may be available prior to the date of legislative enactment to limit the impact of the carried interest legislation with respect to existing LTIPs.  It is, of course, possible that any final legislation could differ from the current proposed version or the measure may not be included in the legislation at all.

Any actions with respect to LTIPs will need to be taken very quickly as it is anticipated that the legislation will be passed shortly.  Executives should be encouraged to seek advice from their financial advisors and to monitor developments carefully.  Relevant terms of existing LTIPs should be reviewed carefully before any decisions are made, for example: applicable notice periods for the exercise of conversion/redemption rights; transfer restrictions and lock-ups; and the timing of decision by the REIT to issue shares or pay cash upon redemption.  Finally, the impact of insider trading policies on executives’ ability to sell REIT shares to fund their tax liability and Section 16 reporting obligations should be taken into account.