A recap of the final carried interest regulations for asset managers

The government has issued final regulations governing the carried interest rules of 2017’s Tax Cuts and Jobs Act. 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.

For asset managers and family offices, carried interest has been in the spotlight since the TCJA. Now, with the much-anticipated final regulations released, there is clarity. Ben Wasmuth, senior manager and member of RSM’s pass-through consulting group breaks down the final regulations with Andy Swanson, a partner in RSM’s Washington National Tax private client services group. They discuss the fundamentals of the mostly favorable regulations and provide thoughts on how asset managers should react.

Here’s a transcript of their conversation, edited for clarity:

ANDY: What are the final carried interest regulations and what do the regulations do?

BEN:  As a compromise or, at least, an effort to have done something, Congress modified the holding period for long-term capital gains attributable to carried interests from one year, which had been the normal period, to three years. Now, this supposedly simple change brought with it a number of complications. Namely, what is a carried interest, and when are gains attributable to it—and not to another interest the taxpayer may hold in the same entity? What about types of gain that have their own, separate holding period requirement? Did they slip through the cracks as an oversight—or were they intentionally left out of the statute?  The statute also included a variety of apparent anti-abuse rules, and no one is quite sure what even the staff was thinking about —all we have are the words. Regulations proposed in mid-2020 attempted to answer some of these questions.

ANDY: And how did they do?

BEN: Well, in the first draft—the proposed regulations—they complicated matters still further.

ANDY: And what happened last week?

BEN: The Treasury Department prereleased final regulations, which generally moderated the harshest or most irrational aspects of the first draft—the proposed regulations.

ANDY: Let me go through those with you one by one. But before I ask about the substance of the regulations, when are they effective?

BEN: They apply to taxable years beginning on or after the date they are published in the Federal Register which has not yet happened, and may not actually happen for some time, due to the expected freeze on regulatory activity by the new administration on Jan. 20. Assuming that the regulations are published in the Federal Register this year, and assuming a calendar-year taxpayer, which constitutes the majority of investment funds and their owners, this means they will first be binding for calendar year 2022—that is, the tax returns to be filed in 2023. However, because in many cases they have turned out to be favorable and a reasonable interpretation of the law, taxpayers may choose to follow them for years prior, as long as they apply them in their entirety for that year and all following years.

ANDY: I know a lot of people were concerned about a rule that said a gift of a carried interest accelerated income tax.  Is that still there?

BEN:  It was changed to a recharacterization rule. If there is gain on a transfer—for income tax purposes—these rules determine its character.  But no actual gain, no tax.

ANDY: Let’s go to the fundamentals.  Do these regulations help define what a carried interest is?

BEN: Arguably, but only at the margins.

From the statute, a carried interest is an interest in a partnership, received in exchange for services.

But it must be for services in an applicable trade or business.

And an applicable trade or business must have some degree—we don’t know exactly how much—of the activities of raising capital, or returning capital, and managing the type of assets that funds typically invest in. Specified assets include stocks, bonds, derivatives, etc., but notably not interests in pass-through entities that conduct operating businesses.

We know what managing assets means, and we think we know what raising capital means, at least in obvious cases where there’s a marketing effort to investors, but there’s still a lot of uncertainty about what it means to return capital.  For most funds, however, they are clearly engaged in raising capital (or gradually returning the capital they raised before the law was enacted) and managing assets—and that’s enough. 

For family offices that have an existing pool of assets—and hire someone to manage it—with no intention to ever distribute the original capital back to any of the family members, but only to distribute income, we’re still in a gray area.  

That certainly wasn’t the focus of the law—and the Treasury apparently didn’t want to spend much time dealing with a peripheral issue—even though it is very important to those affected by it.

ANDY: What do the regulations actually say?

BEN: Well, the regulations confirm that, as long as there is any quantum of both raising or returning capital, and managing specified assets, then the amount of each does not matter as long as the combined activity rises to the level of a business for tax purposes. Of course, that’s not a clear standard either. Furthermore, they do not provide any additional definition of the two prongs themselves. In the case of raising or returning capital in particular, this would have been very helpful.

ANDY: Is there any relief in the regulations?

BEN: Possibly. There is a provision in the statute that says the recharacterization rule does not apply to gain attributable to assets not held for investment by third-party investors, which would potentially reach a typical family office setup. However, this provision requires Treasury and the IRS to issue regulations to be effective. They did not do so in these final regulations; however, they indicated they are still studying the issue.

ANDY: Got it. Suppose I’m satisfied that I in fact have a carried interest for this purpose? How do I distinguish allocations on my partnership K-1 from my carried interest from my return on my invested capital?

BEN: The proposed regulations said that any allocation that’s made proportional to your, and your investors’, relative section 704(b) capital accounts—the technical touchstone for partnership allocations in the plain vanilla case—is a capital interest allocation, provided that your distribution rights are the same as theirs. Exceptions were provided for subordinated interests, and interests that did not carry management fees, but otherwise the test was very mechanical.

ANDY: And what was wrong with this?

BEN: Well, some funds do not maintain section 704(b) capital accounts, for one. Also, some fund managers do not subject their own invested capital to carry; this could have fallen afoul of the proposed regulations. In response to comments of this nature, the final regulations prescribe a rule of reason: an allocation is pursuant to a capital interest if it relates to a carryholder’s invested capital, and participates on the same terms as unrelated nonservice providing partners—that is, generally, the fund’s investors.

ANDY: Does this cover all circumstances then?

BEN: In hedge funds, it is common for a manager’s invested capital to actually be the reinvested proceeds of prior carry, or to use the more common parlance in that sector, prior incentive allocations. Once this has crystalized, it participates on equal terms as investor capital. However, there has not literally been a capital contribution by the manager. Even so, the new regulations allow this to count, in part.

Here, the final regulations provide that a reinvestment of so-called API gain—API (short for applicable partnership interest) is the code’s term for a carried interest—counts as a capital contribution, and can create capital interest allocations. However, API gain is a defined term, and only includes realized long-term capital gains and losses. It appears that unrealized, but still crystalized, incentive allocations do not qualify. Even more extremely, it seems that if a hedge fund manager is allocated interest, dividends or short-term capital gains pursuant to their incentive allocations, than reinvested capital attributable to those amounts would not qualify.

ANDY: That seems severe. Let’s move on to something more taxpayer friendly, the new related party transfer rule. You’ve already told us that this no longer serves as a gain acceleration rule, but what does it say now?

BEN: Before I get into that, let me point out that a related party here is narrower than the usual definition of a related party: it is defined only as a member of one’s family or a coworker in the same applicable trade or business.

With that out of the way, the regulations provide that if you realize gain on the sale of an API to a related party, and otherwise recognize long-term capital gain, then you have to recast some of that as short-term, if it is attributable to unrealized gain in assets held by the fund for less than three years. Some would refer to this as a look-through rule.

ANDY: Are there any other look-through rules that might apply to someone who sells their carried interest?

BEN: There are, and they are much narrower than the one contained in the proposed regulations. Generally, the relevant holding period for purposes of this provision is the asset being sold: If the fund sells an asset, the asset’s holding period controls; if a carryholder sells their carried interest, their holding period in that interest controls. However, there is an exception if the carryholder has held their interest for less than three years starting no earlier than the date which unrelated nonservice partners—again, generally the investors—contribute capital to the fund. If this is the case, then the carryholder must again look through to the assets of the fund, and recharacterize to the extent of unrealized appreciation in less-than-three-year assets. This was largely done to prevent abuse.

In addition, the look-through rule applies if a principal purpose of the transaction was the avoidance of gain recharacterization—standard anti-abuse language found elsewhere in the tax law.

ANDY: There’s sure a lot to take in here. Who is responsible for sorting all this out? The fund…the carryholders…?

BEN: The final regulations impose significant reporting requirements on the funds themselves. They must quantify both the capital and carry allocations, and generally provide all information required to apply the recharacterization rule. That said, any actual recharacterization applies at the ultimate taxpayer level—that is, the individual or trust that actually pays the tax on the allocated income—in part because ultimate taxpayers are required to net their one-to-three-year gain amounts among all carried interests they may hold to determine the recharacterization amount.

ANDY: Last question: Is there anything a fund manager should do right now?

BEN: Generally, these rules should be considered as part of the general pantheon of tax provisions that may affect fund structure, portfolio company exits, manager wealth transfer, or any other significant event in the life of the fund. However, there is one specific action to take right now.

In order to have a valid capital interest allocation which is not subject to the three-year recharacterization rule, the allocation must be clearly identified both in the fund’s partnership agreement—or other governing document—and in the fund’s books and records. No transition or grandfather rule was provided, except that the regulations are not binding until calendar year 2022. Therefore, fund manager should immediately consult with their tax advisors to determine if their partnership agreements, and records, pass muster. Although we expect many agreements will already qualify, the internal record-keeping may not, and the costs of failure on either are tremendous.