Taxing Partnership Profits Interests as Compensation Income

In November 2007 the U.S. House of Representatives passed H.R. 3996, which would have added new section 710 to the code. Section 710 would treat a partner's net income from a partnership as ordinary compensation income, if certain conditions are satisfied. Section 710 was aimed at partners who receive a so-called carried interest in exchange for services provided to the partnership. This provision of H.R. 3996 was removed in conference and did not become law. However, similar legislation is still under consideration in Congress.This report does not take a position on the merits of section 710 from a policy point of view. Rather, it discusses the more specific policy and technical issues that arise if the decision has been made to tax service partners in this manner.The report concludes that section 710 reaches results that in many cases are illogical and inconsistent with the purposes of the section. In some cases, those results are unfair to taxpayers in light of those purposes. In other cases, those results will allow taxpayers to achieve favorable tax treatment that could not have been intended by the drafters of the section. The difficulties in drafting an improved section 710 are not insurmountable, although such a provision will inevitably be complex