New Code Section 1061 partly cuts back the favorable treatment of carried interest profits in a manner quite differently than prior proposals eliminating capital gain treatment altogether. Under Section 1061, gain allocated “in respect of” the carried interest will qualify as long-term capital gain only if the underlying asset giving rise to the allocable gain was held for more than three years. The provision’s language is designed to target managers and sponsors of hedge, venture capital, and private equity funds, though its reach may be broader.
- The Act defines a “carried interest” subject to this rule by reference to a partnership interest received in connection with the performance of “substantial services” in an “applicable trade or business” but leaves “substantial services” undefined.
- An applicable trade or business means either (i) raising and returning capital, or (ii) either investing or developing activities with respect to “specified assets.”
- Specified assets are defined broadly to mean securities, commodities, or real estate held for rental or investment as well as options or derivatives in the foregoing (and interests in partnerships relating to any of the foregoing).
- Exceptions are provided for allocations in respect of either (A) a capital interest commensurate with capital contributions or (B) amounts included in income by reason of a compensatory transfer of the applicable partnership interest upon grant or vesting. Many open issues will need to be clarified by the IRS under both exceptions.
- Also excepted are equity interests granted to employees of entities other than the issuing partnership where the employing entity conducts a business that is not an “applicable trade or business” (but the holder is required to provide services only to that employing entity). This provision’s apparent purpose is to allow key employees of portfolio companies to receive profits interest grants and capital gain treatment under the normal one-year threshold.
- The new three-year holding period also applies to the carried interest itself, meaning that gain from the sale or other disposition of a carried interest will not be long-term capital gain unless held for more than three years.
- The Act creates uncertainty on the scope of Section 1061, in subsection (b), by giving the Treasury regulatory authority to write regulations that determine that the carried interest provision ”does not apply to income or gain attributable to an asset that is not held for portfolio investment on behalf of third-party investors." No further clarification is indicated in the explanation accompanying the Act. This language suggests an outer-limit to the relationships in partnership form where the new three-year holding period should no longer apply. The regulatory exception granted focuses on the absence of two related elements generally central to the fund manager-investor relationship context -- a true third-party investor who is not actively engaged in providing substantial service and to whom the specified asset has a portfolio asset character.
- The carried interest rule will generally apply to all fund managers and employees that hold partnership interests. However, the new rule will not impact funds that typically hold portfolio investments (i.e., specified assets) for more than three years. Notably, the rule also carves out what appears to be an exception for key employees of lower tier operating companies, but further guidance on its application and reach is needed. There may be a further carve-out, as suggested by Section 1061(b), where there is really no partnership or JV with a passive third-party investor, but clarification from Treasury and IRS is needed.