IRS Issued Final Regulations on Tax Treatment of Carried Interest by Arkadiy (Eric) Green, CPA
In January 2021, the IRS issued final regulations concerning the taxation of carried interest under the Tax Cuts and Jobs Act (TCJA) effective for tax years beginning in 2018. These regulations, which modify certain provisions of proposed guidance issued last year, bring mostly welcome changes to real estate businesses and private equity funds.
Carried interest, also known as “promoted interest,” is typically the interest in a partnership’s share of future profits issued to a general partner, fund manager or any other partner in connection with the performance of substantial services. In this sense, carried interest could be viewed as deferred compensation for a partner’s performance of services. However, prior to the enactment of the TCJA, long-term capital gains allocable to these “service partners” with respect to their carried interests could generally qualify for preferential long-term capital gain tax treatment at a top rate of 20 percent rather than the maximum ordinary income tax rate of 39.6 percent (not considering the additional 3.8 percent net investment income (NII) tax that could potentially apply to both capital gains and ordinary income.)
For tax years beginning in 2018, the TCJA reduced the maximum individual ordinary tax rate to 37 percent. It also added to the Internal Revenue Code Section 1061, which generally requires service partners to hold applicable carried interests and the underlying investment assets for a minimum of three years, rather than the prior one-year holding period, in order for the capital gains allocable to the carried interest holders to qualify for the preferential long-term capital gain treatment. More specifically, Section 1061 recharacterizes such gains from the sale of capital assets held for one to three years from long-term capital gains to short-term capital gains, which are typically taxed at ordinary income tax rates.
The Final Regulations
One the most notable changes included in the final Section 1061 regulations is a relaxed set of rules for taxpayers to differentiate between carried interest allocations (subject to the three-year recharacterization provisions) and capital interest allocations, which are not subject to the three-year recharacterization provision under a set of rules known as the “capital interest exception.” Generally, these rules provide that capital interest allocations that are commensurate with capital contributed and determined in a similar manner to what an “unrelated non-service partner” would receive are exempt from the three-year recharacterization provisions that apply to carried interests. To qualify for this capital interest exception, the business’s operating agreements and financial records must clearly distinguish a service partner’s capital interests from his or her carried interest. In addition, the final regulations 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, fund 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: Arkadiy (Eric) Green, CPA, is a director of Tax Services with Berkowitz Pollack Brant Advisors and CPAs, where he works with real estate companies, commercial and residential developers, property management companies, real estate investors and high-net-worth individuals to structure investments and complex transactions for maximum tax efficiency. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at firstname.lastname@example.org.