Carried interests in 2020 and beyond

The Tax Cuts and Jobs Act of 2017 (TCJA) enacted legislation to address partnership carried interests. On July 31, 2020, the Treasury Department finally published long-awaited proposed regulations. This article will address some of the primary considerations for impacted partnerships and taxpayers as the end of the year approaches.

Background

Following almost a decade of being tossed around like a political football, the partnership “carried interest” finally became the subject of direct legislation in 2017. Historically, a carried interest represented a special allocation of profit to the managers of a fund that achieved not only a specified base return for its capital investors, but also significant additional profit above that threshold. The standard split on the excess profit above the targeted return has been 20% for the manager and 80% for the investors. In the arena of investment partnerships and funds, this additional profit would typically be in the form of capital gains recognized on the underlying investments or in the sale of the partnership interest received, thus providing the holder of the carried interest with income taxed at favorable rates in exchange for the management and investment service provided. The rules outlined in section 1061, as enacted in the TCJA, seek to minimize the potential favorable rates for carried interests by requiring a holding period of three years for long-term capital gain treatment instead of the typical one-year holding period.

Although the carried interest structure originated and grew primarily in the financial services industry, the carried interest as well as the related issuance of a profit interest to employees has gained widespread usage through a variety of industries. In turn, this made it difficult to craft legislation to specifically target Wall Street — the primary political target of the legislation. As with any targeted piece of tax legislation, regulations become an important part of defining the boundaries of the rules. With the issuance of proposed regulations in 2020, application of the law gains greater clarity.

The general carried interest rules

The carried interest rules revolve around a few key concepts, most notably applicable partnership interests (APIs) that are issued to a taxpayer in connection with the performance of substantial services in an “applicable trade or business.” The term applicable trade or business is defined in the Internal Revenue Code to mean any regular and continuously conducted activity that consists in whole or in part of raising or returning capital, and either invests in or develops “specified assets.” Specified assets are, in turn, defined in general as securities, commodities, real estate held for rental or investment, cash or cash equivalents, or options or derivative contracts with respect to any such assets. These definitions, as contained within the IRC, were intended to carefully target the three-year holding period rule of section 1061 to specific taxpayers.