UPDATED – Carried Interest Deduction Remains Intact Under New Law by John G. Ebenger, CPA
Posted on August 10, 2022
The sweeping Inflation Reduction Act approved by Congress and signed into law on Aug. 16, 2022, did not include any of the previously proposed restrictions to the beneficial tax treatment of carried interest typically paid to general partners, fund managers or others in connection with their performance. Consequently, qualifying taxpayers may continue to treat carried interest as capital gains subject to a significantly lower tax rate than they would pay on ordinary income.
Understanding Carried Interest
Carried interest, also referred to as “promoted interest,” is the share of an investment’s future profits paid to one of its partners as a reward for investment returns, also referred to as a success fee. Under the Tax Cuts and Jobs Act signed into law at the end of 2017, certain partners may pay lower taxes on these interests, treating them as long-term capital gains taxed at a preferential 20 percent rate plus a possible 3.8 percent net investment income tax (NIIT) when they hold those interests and the underlying assets for a minimum of three years. Assets held for less than the three-year holding period are recharacterized as short-term capital gains taxed as ordinary income at rates that can be as high as 40.8 percent with the NIIT.
Over the years, some policymakers have viewed the preferential tax treatment of carried interest as an unfair tax loophole for the wealthy, while others have considered it an appropriate recognition of a partner’s role to ensure a return on investment for all limited partners and investors. After all, proponents argue, carried interest is a form of profits interest that gives service providers the right to share in future partnership profits. It should not be taxable upon receipt because service providers would not share in any distributions if the partnership liquidated immediately after the issuance of the profits interest.
Final Regulations on Carried Interest
In 2021, the IRS issued final regulations relaxing the rules taxpayers must follow to differentiate carried interest allocations from capital interest allocations. More specifically, capital interest allocations commensurate with capital contributed and determined in a similar manner to what an “unrelated non-service partner” are exempt from the three-year recharacterization provisions that apply to carried interest allocation.
The final regulations also lift some of the previous restrictions that excluded a service partner’s capital interest funded by a loan or advance from another partner (or a person related to another partner) from being eligible for the capital interest exception. Due to these changes, it may be advisable for funds to review their financial documentation, partnership agreement language and any existing or future partner loans if they intend to take advantage of the capital interest exception.
From an estate and gift-tax planning perspective, the final regulations clarify that transfers of general partnership interest to related parties, such as gifts to family members, will not be considered taxable events nor will they be subject to Section 1061 recharacterization unless a gain would otherwise be recognized. There are no gains or losses recognized on gifts or sales to intentionally defective grantor trusts (IDGTs). This is a significant taxpayer-favorable departure from the proposed regulations, which previously called for an accelerated recognition of a gain to the transferor of an applicable partnership interest even when the transaction was an otherwise non-taxable event.
Of special significance to real estate businesses and private equity funds, the final regulations clarify that Section 1231 gains resulting from the sale of property used in a trade or business and held for over one year are excluded from the three-year recharacterization rules of Section 1061. However, there is some concern that Congress may eventually get around to changing the rules to make Section 1231 gains also subject to the carried interest recharacterization provisions. With this in mind, managers should consult with their tax advisors and consider alternative structuring arrangements that could potentially help minimize the application of carried interest gain recharacterization provisions.
About the Author: John G. Ebenger, CPA, is a director in the Real Estate Tax Services practice of Berkowitz Pollack Brant Advisors + CPAs. He works with developers, landholders, investment funds and other real estate professionals as well as high-net-worth entrepreneurs with complex holdings. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or firstname.lastname@example.org.