DealLawyers.com Blog

February 6, 2018

Private Equity: Carried Interest’s Status? It’s Complicated. . .

“Carried interest” is the name given to a general partner’s right to receive a special profits interest in a fund – typically 20% of net profits – that is disproportionate to its capital. Historically, a general partner’s carried interest was taxed at capital gains rates, and not as ordinary income. Many thought that this tax preference was unfair, & some reform proposals called for its elimination.

That didn’t happen under the new tax act, but as this Nixon Peabody blog explains, the treatment of carried interest did become more complicated. Here’s an excerpt:

Congress settled on a provision that largely maintains the historical approach to carried interest tax treatment, and does not seek to re-characterize carried interest distributions to the general partner and its individual owners from capital transactions as ordinary income, so long as a new 3 year holding period is satisfied. The new law is unclear whether the new holding period applies to the investment assets of the partnership and/or to the carried interest held by the general partner and its individual owners.

In order to implement this new treatment, the Act introduces the concept of an “applicable partnership interest” (API) which includes partnership interests that are acquired or held by a taxpayer in connection with a trade or business that consists of the raising or returning of capital and either investment in or development of “specified assets.” Specified assets include investment assets, including securities, debt instruments, commodities, real estate held for rental or investment, cash, and options, among others.

Effective for gain recognized in taxable years beginning after December 31, 2017, the Act provides that carried interest allocated by a partnership to an individual partner will be characterized as short-term capital gain (and therefore effectively taxed at ordinary income rates) to the extent the gain is from the disposition of property in which the partnership’s holding period is less than three years in such property.

There remains much uncertainty about how this new carried interest regime will be implemented – and it is unclear as to whether state and local governments will fall in line with this approach.

Speaking of the states, this Jenner & Block memo says that at least some of them are fighting mad about the continued federal tax preference for carried interests, and are touting the idea of imposing their own “coordinated punitive taxes” on it.  Stay tuned.

John Jenkins