A Primer on Carried Interest

Posted on Wed, Jan 26, 2022 ©2021 Drucker & Scaccetti

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By: Heta Parikh

 

We, in the tax profession, tend to use acronyms and terms that aren’t always well-known by the masses, and “Carried Interest” is one of those terms. The concept is simple enough; however, its application and incorporation into a strategic tax plan can be quite complex, especially with recent changes in the law. Today, we’ll provide an overview of Carried Interests to help you determine if and how to use it in your financial planning.

 

While it has been a topic of discussion for a long time, Carried Interest taxation entered public consciousness more noisily in recent years, when lawmakers focused their reform on the historical Long-Term Capital Gain (LTCG) treatment of a general partner’s contractual share in an investment fund’s profits. Pro-reform political rhetoric provocatively refers to such treatment as a “loophole,” suggesting there is something inappropriate about the application of the LTCG rate, by not imposing tax at the maximum ordinary income rate. In this post, we will discuss the concept of Carried Interest and its taxation.

 

On Jan. 7, 2021, the Department of Treasury and IRS issued final regulations (the Regulations) that provide guidance on the Carried Interest rules, under Section 1061 of the Internal Revenue Code. The Regulations finalize proposed regulations that were issued by the Department of Treasury and IRS on July 31, 2020 (the Proposed Regulations).

 

What is a Carried Interest?

In simple terms, Carried Interests are ownership interests in a partnership that share in the partnership’s net profits and losses, held in connection with performing services. Specifically, under Section 1061, these interests are referred to as an “Applicable Partnership Interest” (API), which means an interest in a partnership, which, directly or indirectly, is transferred to (or held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in an Applicable Trade or Business (ATB).

 

An ATB, in this instance, means any activity conducted on a regular, continuous, and substantial basis, which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of (1) raising or returning capital and (2) either (a) investing in or disposing of specified assets or (b) developing specified assets.

 

Specified assets consist of securities, commodities, real estate held for rental/investment, cash or cash equivalents, options, or derivative contracts. With certain exceptions to Section 1061, an S corporation and a Passive Foreign Investment Company (PFIC), with respect to which the shareholder has a Qualified Electing Fund (QEF) election under Section 1295 in effect (such entity is a QEF with respect to the shareholder), are not treated as corporations for purposes of Section 1061.

 

API Recharacterization and Holding Rule

Prior to the enactment of the Tax Cuts and Jobs Act (TCJA), capital gains generated from a Carried Interest only needed to hold the underlying asset for one year, but with the enactment of TCJA, the holding period increased to three years, with respect to LTCG treatment.

 

Section 1061, later enacted in response to the TCJA, recharacterizes LTCGs held for one to three years as Short-Term Capital Gains (STCG). Under normal circumstances, gains held for one year or longer would qualify for beneficial LTCG rates, but under this rule, gains held for one to three years could be subject to ordinary rates and will be recharacterized as short term.

 

The amount of LTCG treated as STCG under the API holding rule is the "recharacterization amount." (Code Section 1061; Reg § 1.1061-4(a)(1))

 

The Code specifically excludes Section 1231 gains and losses, Section 1256 gains and losses, and qualified dividends, under Section 1061.

 

Impact on Taxable Income

To fully understand Section 1061 and Carried Interests, let’s first discuss the difference between how LTCGs and ordinary income is taxed. Ordinary income is generally taxed at a higher rate than LTCGs — significantly higher rates, depending on the taxpayer’s tax bracket.

 

For example, if you earn a $1 million return on long-term investments in 2021, it will be taxed at the maximum rate for LTCGs, which is 20%. If that same amount was treated as a short-term investment (ordinary), your marginal income tax rate would be 37%.

 

Section 1061 most commonly applies to hedge funds. Funds would pay their fund managers based on performance using assets accumulated in their fund. Fund managers would receive all or partial compensation in the form of LTCGs and receive preferential tax treatment, since LTCGs are taxed at a lower rate. From the perspective of the IRS, fund managers are essentially receiving wages, which should be taxed at ordinary rates. Therein lies the basis for implementing Code Section 1061.

 

Computation of recharacterization of capital gains with respect to Carried Interests is a complex topic. If you need help with understanding and carefully planning issues surrounding Section 1061, we are here for you. Please call on Drucker & Scaccetti to discuss the final changes enacted by the IRS and its potential tax impact on you.

Topics: carried interest, captial gains tax

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