Final Rules Around Carried Interest Prompt Strategic Reconsideration

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This blog post was originally published on October 31, 2020. It was updated January 29, 2021.

The Treasury Department and the IRS recently issued final regulations for the treatment of carried interest, clarifying parts of 2017’s Tax Cuts and Jobs Act (TCJA) to provide additional insight and taxpayer guidance. The final rules released January 7, 2021, incorporate public comments in response to proposed regulations released in July 2020, and in many ways are less onerous than originally proposed.

These changes could impact hedge funds, private equity, real estate funds and other investment funds.

How did the TCJA change taxation of carried interest?

Section 1061 of the TCJA changed the way carried interest – the portion of an investment fund’s returns that is paid to the fund managers or general partners as compensation – is taxed. Carried interest (also known as profits interest, performance allocation or promote) is a partnership interest that is taxed upon receipt of a distributive share of future profits of the partnership. Because carried interest is a share of the fund’s investment earnings, it is generally taxed at a capital gains rate, and not an ordinary income tax rate.

However, the TCJA increased the length of time a fund must hold assets for the gains that managers receive to be taxed at the 20% long-term capital gains rate. The law states that the fund must hold assets for more than three years in order for managers to pay the preferential long-term capital gains rate instead of the 37% ordinary income tax rate. Assets held between one and three years are now subject to recharacterization. Prior to enactment of this law, funds only had to hold the assets for more than one year to qualify for long-term capital gains.

Two important notes:

  • The law exempted some types of corporations from the longer three-year holding period.
  • The law did not change the rules for funds’ limited partners.

What clarifications do the final carried interest regulations provide?

The final regulations – and accompanying preamble – clarify the IRS code and provide computational guidance of the law, providing insight into many areas that had been left open to interpretation in the TCJA. The final regulations were fine-tuned based on public commentary and include practical guidance on how to implement the rules.

These are the key points most funds will want to understand:

  • Partnerships should not recharacterize carried interest gains on the Schedule K-1s they issue. Instead, the long-term capital gains line should have a footnote indicating that it includes an amount related to the carried interest rule for the general partner and that it might need to be recharacterized. This essentially leaves the decision on how to characterize carried interest income up to the general partner and his or her tax practitioner. Funds should consider following this regulation when issuing K-1s for 2020.
  • Carried interest waivers that effectively swap short-term gains for long-term gains may not be honored. Some partnership agreements allow fund managers to waive gains from investments sold in less than three years and recoup those amounts from investments held for more than three years. The regulations specifically note that “these and similar arrangements may not be respected and may be challenged.” Funds may wish to modify these types of agreements to conform to the rules. However, distributing unhedged assets to the general partner will continue the partnership holding period allowing for the three-year period to be met outside the partnership. Distributing assets in-kind should be considered.
  • Only corporations taxed at the entity level are exempt from the three-year holding period. Some funds had interpreted the exemption of corporations to include S corporations or passive foreign investment companies. As many in the industry expected, the final regulations clarify that only C corporations are exempt. There is still doubt as to the legality of this determination.
  • General partners who contribute their own capital into the fund will not trigger this carried interest recharacterization. However, the regulations seem to take a narrow reading of this exception to prevent managers from converting their carried interests into capital interest. Bifurcating the two interests should be priority for 2020 Schedule K-1 preparation. A new requirement in the final rules is that capital interest of the general partner only exists if “Unrelated Non-Service Partners” make up at least 5% of the capital contribution to fund. In addition, reinvestment of carried interest gains into the partnership is treated as a contribution of capital interest by the general partner not subject to the new rules.
  • Certain long-term gain investments not included in recharacterization amount. Items afforded the lower long-term rate without regard to holding period have been excluded: IRC 1256 and 1231 gain/loss; qualified dividends; and IRC 1092(b) mixed straddle gains/losses.
  • RICs/REITs/QEF-PFICs have the option to provide one-year and three-year gain and loss details. These investments passing through long-term capital gains dividends may provide the one-year and three-year holding period information in order to receive the long-term rate on the three-year portion. Otherwise, the entire amount defaults to three years or less, subject to recharacterization to short-term. In addition, any loss on sale of regulated investment company/real estate investment trust (RIC/REIT) held six months or less will be treated as held more than three years up to the three-year gain reported by such RIC/REIT.

In addition to changing tax reporting requirements, these clarifications may also mean some funds should rethink their partnership agreements or structure.

Contact your Kaufman Rossin professional to learn more about these carried interest final rules and how they may impact your investment fund and your tax liability.


Chad Ribault is a Tax-Financial Services Principal at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.

Stephen Ng, CPA, is a Tax-Financial Services Principal at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.

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