Private equity professionals value the carried interest because it allows them to be compensated for their services at long-term capital gains rates. This article provides an update on the status of IRC § 1061 and discusses methods for avoiding its application.
Congress enacted IRC § 1061 during 2017.
Reports indicate that during negotiation of the 2017 Tax Cuts and Jobs Act, White House economic advisor Gary Cohn campaigned to end the benefit of carried interests by taxing all income from carried interests as ordinary income, while Treasury Secretary Steven Mnuchin urged keeping the prior tax treatment with new limits. Mnuchin prevailed with the enactment of IRC § 1061.
How IRC § 1061 works.
IRC § 1061 generally increases the holding period required for long-term capital gains treatment for the carried interests held by PE professionals from more than one year to more than three years. This article identifies some of the planning ideas available for dealing with Section 1061’s three year holding period requirement. Additional planning ideas are discussed in an article found on the Frost Brown Todd website.
IRC § 1061 doesn’t apply to a partnership interest issued in exchange for the contribution of capital or property.
IRC § 1061(c)(4)(B) provides an exception to the three-year holding period rule for any interest that provides the right to share in partnership capital commensurate with the capital contributed to the partnership by the partner. The holder of a carried interest subject to IRC § 1061 might also hold a capital interest not subject to the reach of that statute. One planning basic should be to clearly keep the carried interest distinct from the capital interest for tax reporting purposes. Possible planning ideas include having the partnership distribute or loan funds to the service provider, who in turn then contributes those funds back to the partnership in exchange for the issuance of a capital interest. The parties would need to carefully consider whether any transaction as structured would be respected for tax purposes.
Planning idea – consider issuing equity compensation in a corporation.
Bonus and equity compensation, including options and stock grants, by a C corporation do not fall within the scope of IRC § 1202. Given the reduction in the corporate tax rate from 35% to 21% and the potential availability of the tax benefits of IRC § 1202, many business owners and investors are considering the benefits of operating through a C corporation.
Planning idea – structure the economics to defer the triggering of taxes for the carried interest until the holder achieves the three-year holding period milestone.
This strategy involves either the voluntary or mandatory deferral of allocation of profits during the initial three-year holding period for the carried interest. Once the three-year holding period is achieved, there can be make-up allocations and distributions to the carried interest holder. There are various technical issues and risks associated with using this planning idea that need to be carefully addressed by tax professions before this plan is implemented.