Tax Cuts and Jobs Act Takes Aim at Carried Interest

Now more than ever before, hedge fund and private equity managers (managers) operate under significant pressure and challenges. Between the volatility of today’s markets demand for high returns, government regulations and lower fee income as competition increases, the manager’s job is not getting any easier. And now with the new tax law, the manager’s job may require even more diligence due to certain changes.

In the past (pre-2018), the manager’s and investor’s tax results from any trading decision were generally the same. That changed with the passage of the Tax Cuts and Jobs Act (TCJA) on December 22, 2017, which created a potential new tax effect for managers. After years of wrangling in Washington about reducing or eliminating the carried interest benefit given to managers the TCJA included a new IRC Section taking aim at such.

IRC Section 1061 states that a gain from an incentive allocation on property held for more than one year but not more than three years should be characterized as short-term capital gain if it is in connection with an applicable partnership interest (API). An API is any interest in a partnership which, directly or indirectly, is transferred to the taxpayer in connection with the performance of substantial services by the taxpayer or any other related persons (i.e., a profits interest held by the manager). An API does not include any interest in a partnership directly or indirectly held by a corporation or any capital interest in the partnership which provides the taxpayer with a right to share in partnership capital (i.e., an investor’s interest in the fund).

For taxpayers other than corporations, short-term capital gains are taxed as ordinary income at a maximum rate of 37%, while long-term capital gains are taxed at a rate of 20% (plus, in each case, the 3.8% net investment income tax). Prior to 2018, it was beneficial to hold an asset for more than a year in order to obtain long-term capital gain treatment on the sale of the asset for tax purposes. Investors and managers would both be taxed at the long-term capital gain rate. In the event of an expected price decline, a manager would have to sacrifice the valuable long-term capital gain treatment in order to unwind a position in the stock.

For example, let’s say a manager were to sell stock A after holding it for 364 days and recognize a gain of $1,000,000. At the maximum short-term capital gain rate of 37%, the managers and investors would pay $370,000 in taxes for a net gain of $630,000. However, if the manager waited two more days to sell the stock and it lost $100,000 of value, the sale would still come out net positive. The $900,000 gain would have $180,000 of tax for a net gain of $720,000, because the gain would now be treated as long-term capital gain and, therefore, taxed at the favorable long-term capital gain rates.

Under the TCJA, the only way a manager can receive long-term capital gain treatment on incentive share of a sale is for the fund to hold the asset for more than three years before selling it, while investors could have a long-term capital gain after just one year. In the prior example, although the manager and investors would have the same tax consequences if the stock were sold on day 364, the manager would have a different tax consequence than the investors if the stock were sold on day 366. In that scenario, the gain would still be treated as long-term capital gain for the investors, but the gain to the manager would be short-term capital gain because the stock was held less than three years.

This could create an unintended tax consequence for the manager. What happens if the fund is holding an appreciated stock for just under three years, and all the market signals say that the manager should sell? If the manager sells the stock, he/she will not receive long-term capital gain treatment on the share of incentive allocation from that stock; however, the investors will receive the favorable tax treatment.

IRC Section 1061 does what many in Washington had promised to do in the past: reduce the carried interest tax benefit under certain circumstances. As there has been incomplete IRS guidance issued thus far, many areas of the new law remain unclear. Does this code section create even more questions than answers by providing different tax treatments for certain partners? Only time will tell.