Final carried interest rules generally favorable to taxpayers
Executive summary
The government has issued final regulations governing the ‘carried interest’ rules of the 2017 tax law. Generally, those rules required certain asset managers to hold assets for more than three years, not the normal one year, to obtain long-term capital gain treatment from their carried interest. The final regulations are more taxpayer friendly than the earlier proposed regulations, but still ensure that the fundamental purposes of the 2017 legislation are fulfilled. Most of the changes simply recognize, and correct, computational or administrative problems created by the earlier proposed regulations. The major changes are outlined below.
Capital interest allocations
When a carried interest holder also holds a capital interest in an investment partnership, the regulations properly distinguish the carried interest that is properly subject to the three-year holding period from the capital interest, which is not. The earlier proposed regulations were criticized for failing to properly distinguish the two categories, and the final regulations respond to most of the criticisms – dramatically simplifying the rules for determining which gains are properly allocable to the partner’s capital interest – and thus not subject to the three-year holding period. The general rule is a ‘rule of reason’ based on comparisons to the way allocations are made for investors who hold only capital interests.
Related party transfers
When a carried interest holder transfers an interest to a related party – such as in a gift context – the proposed regulations required partial gain recognition for income tax purposes even though there were questions as to whether that was actually required by the statute. The final regulations eliminate that interpretation, while preserving the legitimate anti-abuse provisions associated with transfers of carried interests. This may be important for estate planning purposes.
In addition, final regulations contain a few other items of note:
- Reporting requirements are largely unchanged in the Final Regulations
- Holding period rules are generally as previously proposed, with some clarification of the limited circumstances in which the sale of a carried interest, held for more than three years, would be tested by reference to the holding period of its assets, which is not the general rule. In non-abusive cases, the holding period for the partnership interest will continue to control.
- Rules surrounding the definition of raising or returning of capital continue to be somewhat unclear, raising some potential issues for family offices and similar arrangements.
Specialists in RSM’s pass-through consulting group and tax generalists serving our financial services clients will continue to scrutinize the details of the new regulations for other concerns of potential interest to asset management entities and others who must deal with these rules.
