Carried interest is generally a profits interest in a partnership granted in exchange for performance of services. A service provider might be granted a profits interest in a fund as incentive in addition to his or her fixed fee. Under prior law, any long-term capital gain (“LTCG”) generated by this profits interest was taxed at preferential capital gain rates (20% plus 3.8% net investment income tax vs. the top individual rate of 37% generally applicable to wages). Some define a loophole as a tax benefit to which he or she is not entitled. Taxing compensation at preferential rates was perceived by Congress to be a loophole and the topic of discussion and proposals for years until the 2017 TCJA made changes to the law.

Effective for tax years beginning after December 31, 2017, the new law increases the holding period required for preferential tax rates from greater than one year to greater than three years for capital gains associated with carried interests. Gain on assets held for three years or less is taxed as short-term capital gain. 

The law applies to gain derived from an applicable partnership interest (“API”), which generally includes any profits interest in a partnership held in connection with the taxpayer's substantial services in an applicable trade or business (“ATB”). An ATB involves raising and returning capital and investing or developing securities, commodities, real estate, and/or certain other assets (for example, a portfolio asset management business). An API does not include any interest in a partnership directly or indirectly held by a C corporation. There are special rules for transfers of any API to a related person. 

There is a presumption that any services performed are substantial services. Once a partnership interest falls under these rules, it retains that character until an exception applies, even if the holder retires. The API may be held directly or indirectly—for example in a tiered structure.

The net LTCG affected can be gain or loss allocated to the owner by all APIs or gain or loss on disposition of APIs. There is a limited “look-through” rule for dispositions at a gain where the holding period is more than three years.

There are five exceptions to treatment of a profits interest as an API. 

The first exception is an interest held by a person who is employed by another entity that is conducting a trade or business (other than an ATB) and provides services only to such entity. 

The second exception is for interests held by a corporation. The regulations limit this exception, in general, to C corporations.

The rules do not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors (sometimes known as the family office exception).

An API will not be an API in the hands of a bona fide purchaser who does not provide services in the ATB, is unrelated to any service provider, and who acquires the interest for fair market value.

The exception causing the greatest interest and discussion is the capital interest exception. The final regulations made taxpayer-friendly changes to the proposed rules. An API does not include a capital interest which provides a right to share in partnership capital commensurate with the amount of capital contributed or the value of the interest subject to tax upon receipt or vesting of the interest. An allocation meets the capital interest exception if the allocation to the holder with respect to the capital interest is calculated in a similar manner to the allocations with respect to capital interests held by similarly situated unrelated non-service partners who have made significant aggregate capital contributions (5 percent or more of the aggregate capital account balance of the partnership at the time the allocations are made). 

Generally, an allocation is not a capital interest allocation if it is attributable to a loan made or guaranteed by another partner, the partnership, or a related person. There is an exception for loans made by another partner if the service provider is personally liable for repayment of the loan.

The regulations require both API holders and the pass-through entities that have issued an API to provide information to IRS. For owners, the regulations state that the owner must file “such information” as IRS may require “in forms, instructions, or other guidance as is necessary for the Commissioner to determine that the Owner Taxpayer has properly complied...” We are still waiting for that guidance. There is similar language for the disclosure by passthrough entities.

The IRS, Treasury, Final Rule is 107 pages. This is only a brief overview of the rules that apply currently. The Biden Administration may bring more changes in this area. As always, if these rules apply to you, please consult your tax advisor.