One of the more controversial provisions is the taxation of "carried interest."  This provision of the bill would convert the gains received by investment managers from capital to ordinary, meaning they would pay tax at a higher rate.

Here's how it works:

Recharacterization as ordinary income

The provision generally treats net income from an investment services partnership interest as ordinary income.  Thus, the provision recharacterizes the partner's distributive share of income from the partnership, regardless of whether such income would otherwise be treated as capital gain, dividend income, or any other type of income in the hands of the partner.  Such income is taxed at ordinary income rates and is subject to self-employment tax.

Definition of investment services partnership interest

In general.          The provision provides that an investment services partnership interest is a partnership interest held (directly or indirectly) by any person if it was reasonably expected (at the time the person acquired the partnership interest) that the person (or any related person) would provide, or already has provided, (directly or indirectly) a substantial quantity of certain services with respect to investment assets held (directly or indirectly) by the partnership.  The services are (1) advising as to the advisability of investing in, purchasing, or selling any security, (2) managing, acquiring, or disposing of any specified asset, (3) arranging financing with respect to acquiring specified assets, and (4) any activity in support of any of the foregoing services.  Activities in support of these services are intended to include supervising others who perform the services as well as assisting others who perform the services.  The definition does not include a real estate partnership.

Examples From Committee Report.         The provision does not apply to services other than those giving rise to an investment services partnership interest.  For example, assume that three individuals form a partnership to operate a biotechnology business; two each contribute $1 million in cash, and the third contributes his personal services as a research scientist.  In the following year, the business profits of the partnership are $300,000, and the partnership agreement provides that each of the three partner's distributive share is $100,000.  The profits are ordinary income to the partners under present law, so the provision does not affect the income tax rate applicable to the partners.  In the following year, the third partner (the research scientist) sells his partnership interest.  Because the third partner's services do not consist of the investment management services described above, the gain on sale of the partnership interest is not subject to recharacterization under the provision.  As another example, assume instead that a partnership of three individuals is formed to manage investments in securities.  The first two individuals contribute $1 million each and the third contributes his personal services advising the partnership as to the advisability of investing in particular specified assets, and managing, acquiring, arranging financing for, and disposing of such assets.  In the following year, the profits of the partnership are $300,000, and the partnership agreement provides that each of the three partner's distributive share is $100,000.  Because the third partner's services consist of the services described above with respect to securities, the third partner's share of profits is subject to recharacterization under the provision.  Similarly, if the third partner (the investment manager) later sells his partnership interest and recognizes gain, the gain is characterized as ordinary income under the provision.

Conclusion

At this time, it is not known whether this provision will become law.  However, Congress is looking for money and has expressed a willingness to target fund managers.  My guess is some form of this concept will be enacted.