Carried Interests Again – and a Reminder About Gifting

The tax treatment of carried interests (sometimes referred to as “promotes”) changed under the Tax Cut and Jobs Act of 2017. The thrust of the change was to establish a new three-year holding period (instead of the standard one-year holding period) before a fund general partner or investment partnership sponsor could access the favorable 20% long-term capital gains tax rate in respect of its carried interest (the tax treatment of the general partner’s or sponsor’s capital investment in the fund or investment partnership did not change). 

Under the 2017 Act, capital gains realized by the holder of a carried interest before the end of the three-year holding period are taxed at ordinary income rates. This has impacted many private equity funds, certain types of hedge funds and some real estate funds, joint ventures, and investment partnerships. For real estate fund general partners, developers, operators, and sponsors earning carried interests, the change has had less of an impact because of a significant carve-out for so-called “Section 1231 property,” which includes most investment real estate held for more than one year (although careful structuring is required to preserve eligibility for the old one-year rule). 

Despite the 2017 Act’s narrowing of what some have referred to as the carried interest “loophole,” many members of Congress were dissatisfied that favorable tax treatment was not eliminated altogether. The objection to long-term capital gains tax treatment is premised on the fact that the fund general partner or investment partnership sponsor is performing services that would generally be taxable at ordinary income tax rates (like a recipient of management fees). But under partnership tax rules, the tax character of the underlying income that generates the carried interest passes through to the partners. If the fund or investment partnership realizes a long-term capital gain, the general partner may receive an allocation of that long-term capital gain (of course if the fund or partnership generates ordinary operating income, the ordinary income may pass through to the general partner as well). If one understands the nature of partnership taxation, one might reject the assertion that there is an abusive “loophole.” But there clearly is a policy decision to be made, one that was made in the form of compromise legislation in 2017.

Yet since 2017, numerous bills have been introduced to Congress to fully close off access to the favorable long-term capital gains tax rate for carried interest holders. None have gone anywhere. Indeed, even necessary technical corrections to the carried interest rule have been stalled in the typical all-or-nothing debate over this long-standing issue. 

So, what has changed in the last couple of weeks? Just another bill to eliminate the “loophole” with little prospect of advancing, this time introduced as the “Bill Pascrell Ending Tax Giveaway Act.” Bill Pascrell was a member of the House Ways and Means Committee (since deceased) who advanced several bills to eliminate historical carried interest treatment. Whatever your view, query whether a legitimate tax policy issue such as carried interests would be taken more seriously if the remedial legislation was not titled with words such as “tax giveaway” and an in memory of honorific (a relatively new phenomenon in the world of tax legislation). Results of the upcoming election will most definitely bring this issue to the forefront of tax reform efforts, along with the question of whether to extend numerous other provisions of the 2017 Act that expire at the end of 2025. As a reminder, this includes the higher lifetime exclusions from the estate and gift tax enacted in 2017, which has prompted many high-net-worth families to accelerate their gifting plans to 2024 and 2025.