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PE fund operations: Carried interest considerations — important updates for 2018

With great fanfare, President Trump signed into law on December 22, 2017, a bill formerly known as the Tax Cuts and Jobs Act (the Act). In addition to the myriad sweeping tax reforms made in the areas of corporate and individual tax rates and related provisions, there were important changes made to the tax treatment of “carried interest” distributions from investment partnerships and other flow-through vehicles. All private equity and other alternative investment fund managers should be aware of these new provisions, which generally take effect from and after January 1, 2018.
 
Carried interest distributions represent the general partner’s (i.e., the fund sponsor’s) entitlement to receive a special profits interest from the fund that is disproportionate to its capital interest in the fund (and typically the fund’s LPA will stipulate that the general partner’s carried interest will be equal to 20% of the net profits of the fund). Prior to the passage of the Act, the U.S. Internal Revenue Code of 1986 (the Code), as amended, did not contain any specific provisions relating to carried interest or its tax treatment (thus, frequent political debates about “closing the carried interest loophole” or “repealing” carried interest provisions can be confusing for most casual observers).
 
Historically, the Code has permitted partners in investment partnerships to pool the capital of investors with the skills of investment professionals and other entrepreneurs in joint profit-making ventures.  To align interests and contributions to the partnership, the Code has treated a partner’s carried interest in an investment partnership’s profits on the same terms as are applicable to the other partners (i.e., capital transactions effected by the partnership lead to allocations of capital gains to all partners, with the effect that all partners receive long-term capital gains treatment so long as the partnership assets disposed of were held for at least one year).
 
While various proposals in the U.S. House of Representatives and the U.S. Senate have been considered in recent years that would seek to dramatically change this regime by taxing all carried interest as ordinary income, doing so would have significant collateral impacts, and various effects on state and local tax laws. Instead, Congress settled on a provision that largely maintains the historical approach to carried interest tax treatment, and does not seek to re-characterize carried interest distributions to the general partner and its individual owners from capital transactions as ordinary income, so long as a new three (3) year holding period is satisfied. The new law is unclear whether the new holding period applies to the investment assets of the partnership and/or to the carried interest held by the general partner and its individual owners.
 
In order to implement this new treatment, the Act introduces the concept of an “applicable partnership interest” (API) which includes partnership interests that are acquired or held by a taxpayer in connection with a trade or business that consists of the raising or returning of capital and either investment in or development of “specified assets.” Specified assets include investment assets, including securities, debt instruments, commodities, real estate held for rental or investment, cash, and options, among others.
 

Effective for gain recognized in taxable years beginning after December 31, 2017, the Act provides that carried interest allocated by a partnership to an individual partner will be characterized as short-term capital gain (and therefore effectively taxed at ordinary income rates) to the extent the gain is from the disposition of property in which the partnership’s holding period is less than three years in such property.
 
This re-characterization rule applies only to APIs, and specifically excludes interests in a partnership held directly or indirectly by any corporation. As such, some observers have noted that an S corporation (a “pass through” entity for tax purposes) could be argued to fall outside the definition of an API. This could lead to some confusion in the marketplace as some fund sponsors might seek to convert their existing general partner LLC entities into S corporations in an effort to avoid API treatment and the limitations of the new law (although presumably Congress or the IRS will take action to provide proper guidance in this area).
 
Some other important takeaways for private fund sponsors, in respect to the Act, are: (i) the granting of a profits interest in the investment partnership (or in the general partner entity) continues to be generally tax free under the new law; (ii) “qualified dividend income” payable under a fund LPA (such as in connection with a ”dividend recap” of a portfolio company) would still be eligible for preferential federal tax rates; (iii) affiliates of taxpayers subject to the new law include certain family members, estate planning vehicles, and certain service providers of the partnership to whom the taxpayer may transfer an API; and (iv) no grandfathering of current profits interests held by a fund sponsor will be applied, and so managers will need to consider the implications for all profits interests they currently hold that will likely be treated as APIs.
 
It is important to note that this new rule does not apply to capital interests with the right to share in partnership capital commensurate with contributed cash, or to the extent already included in income as compensation for services under Code section 83. In this way, any capital (i.e., “skin in the game”) contributed by investment professionals in their own funds should not be subject to the new three-year holding period requirement. In addition, the new law only applies to carried interest, and it generally does not change the one-year holding period for long-term capital gain treatment for federal income tax purposes in other contexts (i.e., other than with respect to an API).

Currently, there is much uncertainty around many of the practical aspects of how this new carried interest regime will be implemented. It is not clear if state and local governments will adopt the same rules, and therefore carried interest could be treated differently for federal and state/local income tax purposes. Congress may introduce technical corrections to the Act, and the IRS and U.S. Treasury Department may issue regulations or other guidance (although it’s not clear if and when such guidance may be forthcoming).

Sponsors of private investment funds should consult with their own legal and tax advisors to understand fully the potential impact of this new law based upon their own particular circumstances.

 

Note: this article is a summary for general informational and discussion purposes only, and should not be considered as legal, tax, or investment advice. 
 


 


 

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