US GPs must pay Medicare tax on carry

New Medicare tax hikes will hit US private equity and real estate fund managers and investors alike beginning in 2010.

The Health Care and Education Affordability Reconciliation Act of 2010 increases the Medicare tax rates on wages from 2.9 percent to 3.8 percent, which will be a blow to fund managers’ salaries. But more painful will be the fact that carry will be subject to Medicare tax for the first time.

“Carried interest from the sale of underlying portfolio companies allocated to fund managers, which is currently taxed at a favorable capital gains rate, will now also be subject to the 3.8 percent Medicare tax,” said Christian McBurney, partner with Nixon Peabody.

Medicare is not currently subsidised by a tax against net investment income and is financed by payroll taxes. The act modifies the Medicare tax to include a tax on net investment income for individuals, trusts, and estates. Not only will GPs have to pay Medicare tax on carried interest, but LPs who fall into those categories will be taxed as well.

The good news is there’s plenty of time for tax planning as the Medicare tax does not go into effect until 2013. Funds could consider selling ‘winners’ in 2010, before the rate increases to 20 percent, said McBurney. “Funds could also consider selling in 2011 or 2012, before the new 3.8 percent Medicare tax takes effect, increasing the top capital gains rate to 23.8 percent,” he added.

Additionally, investment income can be sheltered by any passive losses.

“It appears that passive losses that are not used to offset investment income can be carried forward to offset investment income in a future year,” said McBurney, adding that how the carry-forward will work in all circumstances is unclear. It is not certain whether passive losses that a taxpayer carries forward from years previous to 2013 may be carried forward.

Hedge fund investors and managers will also be impacted.

“Managers of hedge funds where active trading of financial instruments or commodities is conducted will be subject to the 3.8 percent tax hike,” said McBurney.

International investors, however, will not be affected by the tax increase.

“Foreign investors who are nonresident aliens for US federal income tax purposes will continue to be exempt from US tax on their portfolio income if they invest through a blocker entity and will also be exempt from the Medicare tax even if they invest directly in a US fund taxed as a partnership,” he added.