Carried interest tax rules have long offered favorable tax treatment for the general partner of a private investment fund. But is the end in sight? Here’s what you need to know.
What is Carried Interest?
Carried interest is a major source of income for the general partner of a private equity or hedge fund. The general partner is usually a partnership of investment managers who contribute 1% to 5% of the fund’s initial capital. They receive compensation in two ways:
- An ongoing management fee (typically around 1.50% – 2% of the fund’s assets annually)
- Carried interest, also referred to as the “carry,” which might entail 20% of the fund’s profits over a set period, typically annual with the exception of private equity funds.
Carried interest isn’t guaranteed. It’s only created when the fund generates profits. It’s usually tied to a specified rate of return known as profits over the high-water mark or the hurdle rate.
For example, if the fund’s target return is not over the high-water mark or the hurdle rate, the general partner might not earn any carried interest. However, it’s also where the general partner stands to make the most money and receive the most preferential tax treatment on that income.
Carried Interest Federal Income Tax Treatment – The Recent History
Many presidential administrations in the past have attempted to make changes to the way carried interest is taxed. President Obama, President Trump and President Biden have all wanted to eliminate tax treatment for carried interest.
The last time that carried interest tax treatment came under fire was in 2017. Prior to the Tax Cuts and Jobs Act (TCJA), carried interest was taxed at the same rate as long-term capital gains, if the fund held the assets for more than one year.
The TCJA changed that tax treatment by requiring the investment fund to hold assets for more than three years—rather than one year—to qualify for treating any gains allocated to its investment managers as long-term gains. However, as most private equity funds hold their assets for more than five years, the longer holding period requirement didn’t have much of an impact.
The private equity industry has successfully pushed to maintain the carried interest tax break for many years. They argue that the carried interest tax preference encourages long-term investment—particularly in the renewable energy industry—and creates jobs.
They also argue that general partners are more like entrepreneurs who start a new business and, as such, should be able to treat part of their return on investment as capital rather than ordinary income.
On January 7, 2021 the Internal Revenue Service (IRS) released final regulations (the Final Regulations) under Section 1061, which, among other items, provides helpful revisions to previous regulations and address the three-year holding period requirement under Section 1061 so that those who hold certain “carried interests” may qualify for preferential capital gains tax rates.
Carried Interest Federal Income Tax Treatment – The Current Status
Annual management fees are taxed as ordinary income, currently subject to a top tax rate of 37%. However, carried interest is often treated as long-term capital gains for tax purposes, subject to a top tax rate of 23.8% (20% on net capital gains plus the 3.8% net investment income tax).
Some view this tax treatment as unfair because the general partner receives carried interest as compensation for its investment management services. Opponents of the carried interest tax treatment believe it would be fairer to tax carried interest like wages and salary income, subject to a top rate of 37%, as well as employment taxes.
This would treat general partners of private investment funds more like investment bankers and other service providers who pay ordinary federal income tax rates on their salaries and bonuses.
That’s a view shared by President Joe Biden and many members of Congress, which is why carried interest tax rules may be on the brink of change.
Carried Interest Federal Income Tax Treatment – What May Come in the Future
President Joe Biden has called for an end to both the carried interest tax preference and lower tax rates for capital gains.
In a Fact Sheet for the proposed American Families Plan, the Biden administration said the carried interest tax would ensure “hedge fund partners will pay ordinary income rates on their income just like every other worker.” Several lawmakers have also introduced the Carried Interest Fairness Act, which would tax carried interest at ordinary income tax rates and treat it as wages subject to employment taxes.
Biden also proposed raising the capital gains tax rate for households earning over $1 million a year to 39.6%, which is the proposed top income tax rate.
A massive lobbying push from the private equity industry is underway. However, experts agree that general partners of private investment funds will likely see a change in their tax burden.
Lawmakers see carried interest as an easy opportunity to generate additional tax revenue without placing a greater tax burden on middle-class taxpayers. According to a 2018 Congressional Budget Office report, taxing carried interest as ordinary income would raise $14 billion in new revenue over a decade.
Of course, it’s unclear what the final legislation will look like as negotiations are underway in Congress, but the impact of this change, if successful, will likely affect senior professionals at private equity firms the most since they tend to get a bigger slice of the carry.
Learn More about Carried Interest Tax Considerations
It’s crucial to begin analyzing all aspects of carried interest tax changes, as well as other potential tax changes. While there’s still a great deal of uncertainty over how the tax code will be affected, now is a good time to reach out to your Warren Averett tax professional, or have a member of our team reach out to you.