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Ways and Means extender bill hits carried interests, professional S corporations

May 20, 2010

A summary of newest version of the annual lobbyist shakedown, a/k/a the expiring tax provision extension, has been released by the House Ways and Means Committee. To pay for a one-year renewal of the usual expiring corporate welfare provisions (Biodiesel!), the bill would impose permanent tax increases on some professional s corporations. It would also turn much capital gain to hedge fund and private equity partners into ordinary income.

The S corporation tax imposes self-employment tax on S corporation professional activity K-1 income. Under current law K-1 income from professional practices is not subject to self-employment tax, but the IRS often moves K-1 income to owner W-2s and then assesses FICA and Medicare taxes. The attacks the "John Edwards Shelter," but not in all cases. From the Ways and Means summary:

The bill would address this abuse in situations where (1) an S corporation is engaged in a professional service business that is principally based on the reputation and skill of 3 or fewer individuals or (2) an S corporation that is a partner in a professional service business.

We'll have to see the bill language to see what "based on the reputation and skill of 3 or fewer individuals" means. As a shareholder in a nine-shareholder CPA firm, I am suddenly moved to be modest about my own role, at least until bonus time.

The bill zaps hedge funds as follows:

Taxation of carried interest. The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund. To the extent that carried interest reflects a return on invested capital, the bill would continue to tax carried interest at capital gain tax rates. However, to the extent that carried interest does not reflect a return on invested capital, the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income. A transition rule would apply prior to January 1, 2013. This proposal is currently being estimated by the Joint Committee on Taxation.

Presumably this will be based on the carried interest provisions in Sec. 602 of HR 4213, as passed by the House earlier this year, which does little to grandfather existing hedge funds and private equity funds.

I hope to see statutory language by tomorrow.

Kay Bell has more on the extender bill.