US tax reform and fund manager carried interest
1 November 2018
There are various uncertainties regarding the application of the rules for carried interest introduced under US tax reform in 2017.
Tax reform introduced new rules seeking to increase the likelihood that fund managers carried interest would be taxable as ordinary income, rather than long-term capital gain. Unfortunately the legislation was drafted hastily and there are many questions which will need to be addressed either by further legislation or by regulation.
Carried interest is a term used to describe the slice (typically 20%) of super profit (profit in excess of a hurdle) generated on alternative investment funds, which is payable to the investment manager. The carried interest is often structured so that the fund managers own an interest in the underlying fund so that the tax attributes of the underlying investments flow through to the individual managers.
One reason for structuring the carried interest in this way is to enable the individuals to benefit from long-term capital gains treatment when underlying investments are sold. In order to benefit from long-term capital gains treatment, the underlying asset must have been held for more than one year.
There have historically been no special rules for carried interest. Therefore provided that the one year holding period has been satisfied, capital gains flowing through to carried interest holders have qualified for the long term capital gain rates.
For many years there has been debate around whether or not fund managers should be eligible for long-term gain treatment on their carried interest. The debate focused on the issue of whether carried interest should be taxed as an investment or as remuneration for services. If carry were treated as remuneration, then it would be taxable as ordinary income at marginal federal rates i.e. up to 37%.
The trump reforms stopped short of taxing all carried interest as ordinary income, and instead provide that long-term capital gain treatment will continue to apply provided that the holding period exceeds three years. New section 1061 applies to an “applicable partnership interest” (“API”) meaning (very broadly) a partnership interest transferred to the taxpayer in connection with the performance of services relating to investment management. Section 1061 works by increasing the required holding period for long term capital gain treatment from more than one year to more than three.
It is not clear whether the three year holding period applies to the individual’s interest in the carried interest partnership or to the partnership’s interest in the underlying investments, or even both. The lack of clarity is caused by the fact that 1061 applies to capital gains “with respect to” an API. Both gains on the sale of the partnership and gains on the underlying assets are arguably “with respect to” the API. This issue is thrown into sharp focus as we draw close to the end of 2018 when individuals need to start setting aside funds to pay their tax on gains realised this year.
Some commentators have suggested there is authority to test only the holding period of the underlying investments, in which case an executive who has held their carry for less than three years may still be eligible for long-term capital gains treatment provided that the fund held the underlying investment for more than three years. However, bearing in mind the intent of the legislation (to prevent long term gains treatment for carried interest), a more realistic interpretation is likely to be that both the API and underlying investments must have been owned for more than three years.
Transfers to related persons
A further rule introduced by tax reform imposes an automatic tax charge in circumstances where an individual transfers carried interest to a related person. The individual will recognise a short-term capital gain to the extent of any assets held for three years or less. There are many routine circumstances where an individual might typically transfer their interests to a related person for reasons unrelated to income tax. For example they may make a gift to a family trust or an adult child. if the three-year holding period is not satisfied, then the tax charge will arise. What then happens with respect to future carried interest profits subsequently received by the trust or child? Arguably, these are outside of the scope of the new rules so the three year holding period would cease to apply. Can this really be the intention of the legislation, if the original service provider is still providing services to the funds…?
The provisions do not include any grandfathering rules. Therefore it would seem likely that the three-year holding requirement applies to partnership interests and fund investments acquired before 2018.
Finally, it would appear that many types of real estate are not caught by these rules. The reason for that this is that section 1061(a)(2) which increases the required holding period of three years, does so by reference to section 1222. Section 1222 applies only to the sale or exchange of capital assets. Real property used in a trade or business is not a capital asset.
It would be somewhat odd if real estate had been excluded from the rules on purpose, however, legislative change will probably be required in order to rectify this.
Guidance from the IRS clarifying the above matter will hopefully be forthcoming in the coming months.