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IMA Tax Policy Blog

Critical Issues Regarding Carried Interests

an excerpt from “Tax Reform Progress Report”

Baker Tilly Virchow Krause, LLP is an IMA Member

The Tax Cuts and Jobs Act (the Act) became law approximately six months ago, significantly transforming how we compute federal income taxes.

In general, the receipt of a capital interest for services provided to a partnership results in taxable compensation to the recipient. However, a safe harbor rule allows that the receipt of a profits interest in exchange for services is not a taxable event if the holder is entitled to share only in gains and profits generated after the date of issuance (and certain other requirements are met). In the context of hedge funds, private equity funds, real estate funds, etc., a profits interest granted to the fund manager is often known as a “carried interest.”

The TCJA added section 1061, which recharacterizes certain income attributable to carried interests as short-term capital gain (STCG), rather than long-term capital gain (LTCG). Section 1061(a) provides that a three-year holding period is now required in the case of certain net LTCG with respect to any “applicable partnership interest” (API) held by the taxpayer. Capital gains that do not meet the three-year holding period will be treated as STCG and, therefore, taxed at higher ordinary rates.

The new rules apply to API held or received in connection with the performance of services in any “applicable trade or business.” An applicable trade or business means any activity that consists in whole or in part of the following: (1) raising or returning capital and either (2a) investing in (or disposing of) “specified assets” (or identifying specified assets for investing or disposition), or (2b) developing specified assets. Specified assets means securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to such securities, commodities, real estate, cash or cash equivalents as well as an interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing.

 

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