What Fund Managers Need to Know About Final Carried Interest Regulations for Investment Funds
Background of Carried Interest
Historically, fund managers have been compensated for their services to an investment fund by receiving a carried interest in the investment. A carried Interest is an ownership share of a partnership that was transferred to the holder (owner) for the performance of services. Many times, the transfer is not the result of a cash or capital investment by the service provider and the ownership share transferred has a fair market value of $0. The carried interest usually grants the right to receive a share of the profits earned by the investment fund based on pre-determined fund performance hurdles. Prior to the enactment of IRC 1061 many times the income allocation from the investment fund to the carried interest holder was income characterized as long-term capital gains and subject to lower tax rates compared to what would have been compensation subject to ordinary income tax rates.
IRC 1061 was enacted on December 22, 2017, as part of the Tax Cuts and Jobs Act and applies to tax years beginning after December 31, 2017. The law recharacterizes what would have been long-term capital gains as short-term capital gains with respect to allocations from the carried interest known as an applicable partnership interest (API). The regulations that came after the enactment of IRC 1061 were to clarify many of the questions about the new law. The final 1061 regulations were published on January 7, 2021.
What is an Applicable Partnership Interest?
API’s specifically relate to an interest received in connection with the performance of substantial services by the taxpayer or related person who is in the regular, continuous business of raising or returning capital, investing assets, or developing these assets. There is a non-portfolio interest exception referred to as the Family Office exception where the holding rules to do not apply to any asset not held for portfolio investment on behalf of third-party investors.
Two Important clarifications on Final Carried Interest Regulations
1. Certain Gains Excluded
One clarification in the finalized regulations relates to the exclusion of certain long-term capital gains from the 3-year holding period requirement for real estate sales and gains commodities contracts. IRC 1231 gains related to the sale of real property and IRC 1256 long-term gains related to commodities contracts are specifically excluded from recharacterization as short-term gains.
2. The Look-Through Rule
Generally, the holding period for the carried interest is either the holding period of the applicable partnership interest or the holding period in the partnership of the underlying asset. The final regulations clarify that the look-through rule applies to the extent the holding period of the API is greater than 3 years, and the API would have a holding period of three years or less if such holding period did not begin until the date that Unrelated Non-Service Partners are obligated to contribute substantial capital partnership, or a transaction or series of transactions has occurred with a principal purpose of avoiding application of Section 1061. The goal of the regulation is to prevent managers from creating dormant partnerships to start the holding period and then later having equity partners contribute capital.
There are many more clarifications in the final carried interest and a complete review of your fact pattern should be done to provide a partnership interest holder with the information needed to comply with the recharacterization requirements.
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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.