You may have seen news about a potential tax increase on the "carried interests" of hedge fund managers and dismissed it, first because you refused to worry about the tax problems of some fat cats in Connecticut but also because it seemed to have no relevance to your general business practice. Think again. The proposed tax would have a reach far beyond hedge fund managers and may become a scale-tipper when you decide whether to recommend a partnership (or LLC) or a corporation for your client's new business.

H.R. 4213, "The American Jobs and Closing Tax Loopholes Act," narrowly missed passage by the Senate on June 24, 2010. The Act would deny capital gains rates to income from certain partnership interests referred to as "carried interests," thereby changing the tax rate on the partner's profit share from 15 percent to potentially as high as 42.5 percent. This change was scored as raising as much as $24 billion, however, and, given the never-ending need of Congress for revenue raisers, it is generally thought to be a question of when, not if, the bill will pass.

In general, carried interests are interests that receive a share of the profits of the partnership but that are not contingent upon a proportionate capital contribution to the partnership. Many businesses in partnership and LLC form, particularly those in the securities, real estate, and oil and gas industries, as well as entrepreneurial start-ups, have traditionally structured the compensation of the managers or developers of the business to include a carried interest. Use of a carried interest allows the investment managers, developers or entrepreneurs to participate in the partnership's upside without a significant front-end capital contribution.

In the past, to the extent a partnership had capital gains from, for example, the sale of stock, securities, or real estate, the partner's share of that gain was also treated as capital gain on the partner's tax return, even though the partner may not have contributed capital to the partnership. Similarly, if the partner sold the partnership interest, the partner recognized capital gain on the sale.

The proposed tax change is based on the theory that, if the partner did not contribute capital to the partnership and yet receives a share of its profits, and if the partner is providing advice or management services to the partnership, then the profit share must really be compensation for services. Then, as the theory goes, if the profit or gain is really compensation for services, it should really be taxed at ordinary income rates, just like other compensation for services, such as salaries. The concept sounds reasonable, except that it throws out the window close to a century of precedent in partnership tax treatment. One reason that consistency in the tax law is valuable is that it allows businesses to plan their affairs with some hope that actual results will match projections. Imagine the magnitude of this change: I don't want to be the one to break the news to a real estate developer that when the shopping center he developed finally sells, he'll be paying ordinary income tax rates on his gain.

The proposed legislation would change the tax rate from the 15 percent rate on capital gains to the ordinary income rate, which in 2011 is expected to revert to 39.6 percent. In addition, these amounts would be subject to self-employment (Social Security) taxes, which generally figure at a rate around 2.9 percent, suggesting a potential tax rate of as much as 42.5 percent.

The proposed legislation also would change the rates on not just the profits distributed by the partnership to the partner but also on the gain on all sales or other dispositions of the partnership interest. The current proposal does not define "disposition" to exclude transfers of the interest that otherwise would be nontaxable, such as an incorporation. For example, under the proposed legislation, the incorporation or liquidation of a partnership or LLC in preparation for an IPO would trigger ordinary income for partners with carried interests, even though the partners may not receive any cash in the incorporation.

A partner's profits would not be subject to ordinary rates if the partner contributed capital to the partnership in an amount that is proportionate to the capital contributions of the other partners. Therefore, one way to avoid the impact would be to identify a contribution of capital for the partner. This is not likely to be a very useful exception for most clients, however, since the very reason that they are receiving a carried interest is their lack of seed capital to contribute.

Although this change in tax treatment was first proposed in 2007, it has not been enacted due to heavy lobbying by the securities industry. Compensation structures in the financial sector have come under increasing scrutiny, however, and hedge fund managers don't get a lot of sympathy votes. In the current economic and regulatory climate, it appears likely that some version of the proposal will be enacted this year. Congress also needs this revenue-raising provision to offset the cost of a tax extenders package. The earlier versions of the proposal targeted hedge fund managers, but the more recent versions have broadened the application in order to maximize the revenue.

The latest version extends beyond securities investment firms to any partnership or LLC if a partner does not contribute proportionate capital and receives the partnership interest for advising or managing the partnership's assets, including real estate and interests in other partnerships. Now, in addition to the securities industry and many other business groups, the real estate industry has been lobbying hard against enactment, pointing to the precarious state of commercial real estate today and the potentially devastating impact of increased taxes on the real estate industry.

The effective date of these rules is expected to be post-enactment, without any grandfathering for existing partnerships. Therefore, any post-enactment partnership distributions or sales would be subjected to ordinary income rates when the partner holds a carried interest. Tax lawyers are busily considering structures that could reduce the impact of the change but, as the title of the "Closing Tax Loopholes Act" would suggest, do not expect any quick fixes. The proposal even contains what is referred to as an "anti-abuse" provision that could be loosely paraphrased as "if you are thinking about structuring to avoid these rules, it won't work" or, put into the words you use with your children, "don't even think about it."

As you can see, we are about to have a whole new cost-benefit analysis to perform when advising on business structures. And you thought choice-of-entity criteria were well-settled and straightforward. On the bright side, you may get the opportunity to be your clients' hero by protecting them from a looming tax problem.

Barbara Spudis de Marigny is a partner in the Houston office of the law firm of Gardere Wynne Sewell LLP, where she specializes in the taxation of partnerships and LLCs.