A new House bill would repeal most of the remaining tax benefits for carried interests held by managers of private equity funds, hedge funds, and certain other investment partnerships. The receipt of a profits interest would not be taxable but any income or gain later realized would be ordinary income and subject to self-employment tax. The bill would effectively remove the existing favorable rules for real estate funds, and for assets held for more than three years. This bill would generally not be retroactive, but other proposals may emerge as Congress considers this longstanding and controversial issue. Unfortunately, it is not possible to predict, at this point, what actions if any Congress will take in this area.
Carried interest and other profits interests
Under current law, fund managers holding a carried interest (a type of partnership profits interest, sometimes called ‘carry’) receive shares of the fund’s gain. That gain receives long term capital gain treatment if certain requirements, principally holding period requirements, are met. Section 1061, enacted in 2017, generally requires a three year holding period for gain with respect to carried interest to attain long term capital gain characterization. Long term capital gain is subjected to lower federal income tax rates than ordinary income.
Partners in a partnership generally are not taxed on their initial receipt of profits interests (such as carried interests), provided that they are received when liquidation of the partnership would result in no distribution with respect to the profits interests. The IRS endorsed this treatment in two Revenue Procedures, Rev. Proc. 2001-43 and Rev. Proc. 93-27. The partners are, of course, subject to tax if and when they actually receive a distributive share of partnership profits.
Outline of proposal
The latest legislative proposal to tax gain with respect to carried interests as ordinary income is quite thorough. The proposal would codify the generally favorable treatment of receipt of a profits interest as nontaxable. A carried interest’s share of partnership gain, however, would be targeted for ordinary income treatment. If enacted as proposed, the ordinary income recharacterization would in many cases apply to carried interest gain recognized after the enactment date.
In addition to making long-term capital gain treatment unavailable, the proposal aims to: (a) make the section 1202 capital gain exclusion on sale of qualified small business stock unavailable, (b) subject gain with respect to carried interests to self-employment tax, and (c) heighten tax penalties for certain tax understatements attributable to carried interests.
Proposed carried interest provisions
The proposal’s primary effect would be to recharacterize net capital gain (a defined term generally representing net long-term capital gain over net short-term capital loss) from an “investment services partnership interest” as ordinary income. Net capital losses would similarly be recharacterized as ordinary losses, but only to the extent that net capital gain was previously recharacterized as ordinary income—with the effect that a carried interest holder would not be able to obtain an overall benefit over the life of their carried interest from any loss recharacterization.
Also, in an override of general partnership tax principles, the proposal would require a carryholder that receives an in-kind distribution from a partnership with respect to that carried interest to immediately recognize any unrealized gain in the distributed property. This gain would be treated as ordinary income, regardless of the character of gain the property would otherwise generate if sold.
Since the proposal would largely require all capital gains with respect to carried interests to instead be treated as ordinary income, the existing three-year holding period rule of section 1061 would be largely mooted. The proposal would therefore repeal section 1061. Note that, although this proposal and section 1061 both address similar economic interests, the definition of a carried interest under section 1061 is not exactly the same as under the proposal.
Proposed effective date
The proposal’s income recharacterization rules generally would apply to taxable years ending on or after the date it is enacted. Therefore, these proposed rules could apply to taxable events which would have already occurred at the time of passage. However, the effect general net capital gain recharacterization rule (not the property distribution rule) would be limited to the lesser of the net capital gain for the entire year of enactment, or the net capital gain taking into account only gains and losses from the portion of the year after enactment. This could result in favorable treatment for pre-enactment gains, while retaining the ability of pre-enactment losses to offset post-enactment gains (reducing the amount recharacterized as ordinary income).
In addition to providing for gain recharacterization, and sometimes acceleration, with respect to carried interests, the proposal would also subject all income with respect to covered carried interests to self-employment taxation, regardless of any other exception from the self-employment tax rules that might apply.
Special penalty provisions would also apply to certain attempts to avoid the rules provided for in the proposal. In particular, the typical 20% accuracy-related penalty would be raised to 40% of any underpayment related to such attempts. In addition, the generally applicable ‘reasonable cause’ exception from penalty application would be limited in a manner to that currently applied to corporate ‘tax shelter’ transactions.
The latest legislative proposal to tax gain with respect to carried interests seeks to apply ordinary income treatment to carried interest regardless of the holding period for the interest or the partnership’s gain property. While passage of this proposal is neither certain nor imminent, it may be worthwhile for fund managers together with their tax advisors to consider alternatives and options that may be preferable if the proposal passes.