U.S. lawmakers have taken another step toward closing a perceived loophole that allows certain income earned by investment fund managers to be taxed at favorable rates. Managers of investment funds, e.g., private equity, venture capital, real estate, and hedge funds, are typically compensated via allocations of gain upon the disposition of underlying investment property. Under current law, these so-called “carried interest” allocations are generally taxed as capital gains. The long-standing general rule is that gains on underlying investment assets held for more than one year are considered long-term capital gains and taxed at favorable rates.
However, following the enactment of the 2017 Tax Cuts and Jobs Act (TCJA), carried interest allocations are treated as long-term capital gains only if the investment property was held for more than three years. Failure to hold the investment assets for more than three years results in the carried interest gain allocation being recharacterized as a short-term capital gain. These recharacterized gains are then taxed at less favorable ordinary income rates.
Since the Tax Cuts and Jobs Act, additional proposals have been put forth to increase tax on carried interests and close the perceived carried interest loophole. As described in the Treasury Department’s Green Book, the Biden Administration proposes generally taxing as ordinary income a partner’s share of income on an “investment services partnership interest” regardless of the character of the income at the partnership level. This rule would apply only to the extent the partner’s taxable income from all sources exceeds $400,000. In general, these proposed rules would apply to the same partners as are currently subject to recharacterization under the 2017 Tax Cuts and Jobs Act.
On February 15, 2021, the U.S. House of Representatives Ways and Means Committee proposed the Carried Interest Fairness Act of 2021 (H.R. 1068). On May 12, 2021, the U.S. Senate Finance Committee proposed a similarly worded Carried Interest Fairness Act of 2021 (S. 1598). Each of these proposals would modify the taxation of carried interests in a manner that is generally consistent with the proposal described in the Green Book. In summary, the Carried Interest Fairness Act of 2021 would seek to tax all carried interest allocations at ordinary rates regardless of the character of income determined at the partnership level, and only for taxpayers with taxable income exceeding $400,000.
Ending the Carried Interest Loophole Act
Notwithstanding the proposed Carried Interest Fairness Act of 2021, on August 5, 2021, the Senate Finance Committee introduced the Ending the Carried Interest Loophole Act (S. 2617). Based on preliminary reviews of the bill, its enactment would likely have a significant impact on carried interest partners.
The bill provides that a taxpayer holding an “applicable partnership interest” would be treated as recognizing ordinary income, subject to income and self-employment taxes, equal to the partner’s “deemed compensation amount.” Based on the definitions contained in the bill, most fund managers holding profits interests in a fund partnership would be treated as holding an applicable partnership interest.
A taxpayer with a deemed compensation amount would concurrently recognize a capital loss in an equivalent amount. The effect of this proposal appears to be the acceleration of ordinary taxable income, regardless of whether there has been an actual disposition event, with a capital loss that may be available to offset future capital gain allocations resulting from actual dispositions of portfolio investments.
The deemed compensation amount would be equal to a percentage of increases in fund invested assets multiplied by the carried interest partner’s highest profit allocation percentage. The percentage of fund assets used in the calculation would be equal to the par yield for five-year High Quality Market (MQM) corporate bonds plus nine percentage points.
For example, assume a newly formed fund has $100 million of invested capital as of the end of calendar year 2022, and the fund manager is entitled to a maximum carried interest allocation equal to 20% of fund gain. Further, assume the MQM rate is currently 3%, resulting in a percentage of fund assets to be used in determining the deemed compensation of 12% (3% MQM rate plus 9%).
Based on these facts, the fund manager would be required to recognize a deemed compensation amount of $2.4 million with an equal capital loss of $2.4 million. If at the end of calendar year 2023 the fund’s invested capital has increased to $150 million, the fund manager would have an additional deemed compensation amount of $1.2 million with an equal capital loss of $1.2 million.
It is important to note that the Ending the Carried Interest Loophole Act is currently proposed legislation and whether the bill will be enacted as drafted is uncertain. Awareness of this proposed legislation and its progress within the Senate and House of Representatives is strongly encouraged, so that affected taxpayers can consider taking proactive steps to mitigate the impact of these rules should they become law. As the congressional process unfolds this summer and fall, practical steps may become advisable.
