Proposals to tax the compensatory portion of a service partner's return as ordinary income have gained momentum and enactment of carried interest legislation seems inevitable, driven by concerns about fairness and revenue. A leading legislative proposal (modified and reintroduced as H.R. 1935) would add new § 710 to the Code. Proposed § 710 is widely portrayed as taxing distributions to a covered service partner at ordinary income rates, in keeping with the view of taxing distributions to service partners at ordinary income rates as "probably the most appealing policy option," but the actual operation of the new provision is much more complex. The reason is that § 710 would recharacterize only a portion of a service partner's distributive share as ordinary income, while the tax treatment of actual distributions to a service partner would depend on the interplay of § 710 with the rest of Subchapter K. Such a hybrid distributive-share approach would produce results that cannot easily be reconciled with the broader structure of Subchapter K.

The article explores the exception for a qualified capital interest when a service partner's share of partnership income is recharacterized as ordinary income and distributions are deferred. A simple example is used to illustrate how the statutory mechanics of § 710 bifurcate a service partner's profits interest into a stream of compensatory return (taxed as ordinary income) and investment return (potentially taxed as capital gain) on reinvested deferred salary. The article suggests that § 707(a)(2)(A) might be modestly expanded to provide a narrower, more focused approach to taxing compensatory arrangements that potentially minimize taxes, without permitting undue deferral. Regardless of which approach Congress adopts, it is essential to consider carefully the interaction of carried interest legislation with the broader framework of taxing deferred compensation under §§ 83, 409A, and 457A.