Dallas, Texas, March 2018 – The “Tax Cuts and Jobs Act” includes a provision dealing with the treatment of carried interest.
Carried interest is defined as a share of the profits on an investment paid to a “manager/partner” in excess of the amount that the “manager/partner” contributes to the partnership. It is a performance fee rewarding the “manager/partner” for enhancing performance of the underlying asset. It often results in a recharacterization of income to the “manager/partner” from ordinary income to a more favorable capital or 1231 gain.
Pre-December 22, 2017:
- A profits interest in a partnership is any interest other than a capital interest. Receipt of a profits interest in a partnership (“carried interest,” “promoted interest,” or “promote”) for services is generally not a taxable event for the partnership or the partner. This is because at the time the interest is received the profits interest entitles the holder to a share of the gains and profits generated after the date of issuance, but does not give the holder a share of the proceeds upon an immediate liquidation of the partnership. In other words, the value of the profits interest when received is zero.
- In a typical private equity fund, the general partner receives its carried interest in exchange for providing investment management services to the fund; while the limited partners provide the substantially all the fund’s capital. In general, the gain from the sale of capital assets owned by the fund will pass through to the partners (general and limited) as capital gains, and qualifies for long-term capital gains tax rate, if the fund held the asset for more than a year.
- In the real estate industry, the general partner, usually the developer, receives its carried interest to compensate for the substantial risks taken during the project development. If the property is held for more than one year, when it is sold at a gain, the Sec. 1231 or capital gain will pass through to the partners, both general and limited.
- Under Sec. 83, if property is transferred in connection with the performance of services, the service provider generally must recognize income for the taxable year in which the property is first substantially vested. Under Sec. 83(b), the service provider may elect within 30 days to recognize income, even if the property is “substantially nonvested” (subject to a substantial risk of forfeiture that is not transferable) at the time of the transfer.
- The new law imposes a three-year holding period requirement for qualification as long-term capital gain with respect to any “applicable partnership interest” held by the taxpayer. We can assume this includes 1231 gains even though not specifically stated in the new law.
- Sec. 83 does not apply to the transfer of a partnership interest to which this provision applies.
- The new law would apply to partnership distributions and dispositions of partnership interests.
- “Applicable partnership interest” is any interest in a partnership that, directly or indirectly, is transferred to (or held by) the taxpayer in connection with performance of services in any applicable trade/business.
- Applicable trade or business is a trade or business conducted on a regular, continuous and substantial basis consisting of raising or returning capital and either (1) investing in, identifying, or disposing of specified assets or (2) developing such assets.
- Specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing.
- The new law imposes a three-year holding period requirement on the underlying investments in order for the “carried interest” to qualify as long term capital gain, rather than ordinary income. If there is a sale, exchange, or redemption of a partner’s interest, the three-year holding period applies to the partner’s holding period of the “carried interest”, not the underlying assets.
- The new law is effective for tax years beginning after 12/31/17. Please note there is no language included that grandfathers existing profits interest held prior to the enactment date.
If you have questions about how provisions of the new law will affect you, please consult the Howard team and we will be happy to walk through your specific situation. Howard aims to share valuable insight that can help you prepare for the months ahead on your personal returns, as well as in businesses so we encourage you to visit the news section of our website where we will continue to post updates and announcements.
: This treatment doesn’t apply if (1) profits interest relates to certain and predictable stream of income from partnership assets; (2) within two years of receipt, the partner disposes of profits interest; or (3) profits interest is in a publicly traded partnership.