Tax Reform Swings a Hand Ax at Carried Interests; What Does it Mean and How Can I Plan Around It?
While tax reform has a long march before becoming law, the amended House of Representatives bill passed yesterday swings an ax at lower-tax-rate-capital-gain-eligible “carried” partnership interests, though it swings a smaller ax—like a hand ax rather than a full-sized ax—than proposals in years past.
This latest proposal focuses on limited industries and allows an escape hatch for interests held more than three years. Here are the details:
How Do I Know if I Have a Carried Interest, and Why are Carried Interests Special?
The phrase “carried interest” applies to a partnership interest granted to a partner for services. The idea is that the capital-investing partners “carry” the service partner, who does not make a capital contribution in proportion to the service partner’s interest.
Partnerships often structure carried interests to have little or no value at grant, causing the recipient to recognize little or no wage or other compensation income at that time. Later, if the partnership recognizes long-term capital gain, the partnership allocates part of that gain to the service-providing partner. This results in the service partner paying tax at a tax rate as little as half the rate on wage or compensation income (approximately 20%, as compared to approximately 40%, depending on the circumstances).
Why Change the Tax Treatment of Carried Interests?
Critics complain that carried interest partnership allocations amount to a bonus that should be taxed at the higher ordinary rates, like wage income and other incentive compensation. The most vocal criticism focuses on hedge funds, private equity firms, and real estate investment firms, where critics see carried interest allocations as the equivalent of management fees. Past Congressional proposals would have recharacterized a percentage or all partnership allocations to carried interests as compensation income, without regard to industry.
Carried interest advocates respond that many carried interest holders invest years of effort before receiving an allocation to their partnership interests, and therefore make the equivalent of an investment associated with a capital contribution.
Proposed Changes in the House Bill
The amended House bill takes a middle ground between the current law and prior Congressional proposals to curb the eligibility of carried interests for long-term-capital gain allocations. The bill focuses on carried interests in hedge funds, private equity firms, and real estate investment firms, not traditional operating businesses.
In targeted firms, the bill allows a partnership to allocate long-term capital gain to a carried interest partner who has held his or her partnership interest more than three years. If the partner has held the interest for three years or less, the proposal recharacterizes the allocation as short-term capital gain. In most cases, short-term capital gain characterization results in income taxation at the same rate as wage or other compensation income, but still allows the partner to avoid employment taxes.
It remains uncertain whether this proposal will survive reconciliation with a to-be-passed Senate tax reform bill.
Future Planning
Even if the proposal becomes law, look for motivated taxpayers to form “shelf” entities to begin the running of the three-year holding period while undertaking limited business activity. The taxpayers will then have such partnerships ready to use in the future when a more substantial opportunity arises. Others will design hybrid debt-equity capital structures such that even service-providing partners’ interests qualify as capital interests rather than carried interests.