The tax benefits associated with carried interest have been on the political "chopping block" for several years, with leaders in both parties threatening to curtail the benefit. Most recently, during the 2020 campaign, President Biden repeatedly called for reforming the tax code to close corporate tax loopholes and requiring the wealthiest Americans to pay their fair share in taxes. Instead of specifically calling for the elimination of the "carried interest loophole," Biden proposed a more general change to the tax treatment of long-term capital gains for high-income taxpayers by requiring those taxpayers with income in excess of $1 million to pay tax on such gains at ordinary income rates (i.e., up to 39.6% under his plan) instead of the current preferential rate of 20%. This broad change to the tax treatment of long-term capital gains would have effectively eliminated the "carried interest loophole" for high-income taxpayers.
The carried interest structure is often used by investment funds to incentivize fund managers. A typical structure could resemble the following:
Funds are typically organized as legal partnerships (e.g., Delaware limited partnerships). Fund managers are often entitled to a percentage of the fund's profits if the fund performs well. An interest in the future profits of a partnership (called a "profits interest") is a form of partnership interest that is taxed under the relevant partnership tax rules (i.e., Subchapter K of the Internal Revenue Code). Those rules provide that income and loss allocated to a partner – whether a "profits interest" partner, like the fund manager, or a "capital interest" partner, like the investors who put in money – retains its character when allocated to the partners in computing their income or loss for the year. The rule draws from the historical principle that partnerships are an aggregate of their individual partners – not a separate taxable entity.
Therefore, if a fund organized as a partnership (whether hedge, venture, private equity, or real estate) exits an investment after 5 years for $50 million that it purchased for $10 million, thus generating $40 million in profit (or, in tax terms, long-term capital gain), and 20% of that profit (or long-term capital gain) is allocated to the fund manager as a "success fee" on the investment, the fund manager reports its $8 million in earned profit as long-term capital gain. In most other industries, success fees and other forms of compensation for services are taxed as ordinary income, which is why this tax result is pejoratively referred to as the "carried interest loophole." The term "carry" derives from the sixteenth century term for the 20% fee ship captains were paid on cargo carried on behalf of others.
Fast forward to May 28, 2021, when the Biden administration fleshed out the details of its revenue-raising proposals in the "General Explanations of the Administration's Fiscal Year 2022 Revenue Proposals" (commonly referred to as the "Green Book"). The Green Book does not have the force of law. Rather, it is the Biden administration's "wish list" of tax law changes. These proposals must be separately introduced and passed by Congress to become law.
The Green Book targets the carried interest loophole in two ways. First, it includes Biden's broad campaign promise of taxing long-term capital gains (and qualified dividends) as ordinary income for taxpayers with adjusted gross income in excess of $1 million (but only to the extent it is in excess of $1 million). Second, it proposes to treat all income in respect of a carried interest (defined as an "investment services partnership interest") as ordinary income subject to self-employment taxes if the partner's taxable income (from all sources) exceeds $400,000. The second proposal is similar to the previously failed legislation repeatedly introduced in the House by Rep. Sander Levin (D-MI) from 2007 to 2015, known as the "Carried Interest Fairness Act" (CIFA).
The CIFA was recently reintroduced in the House by Rep. Levin (H.R. 1068) with companion legislation in the Senate by Sen. Tammy Baldwin (S. 1598). The Tax Cuts and Jobs Act of 2017 only mildly addressed carried interests – by increasing the required holding period from 1 year to 3 years for long-term capital gains treatment for fund managers.
Given that both an increase to the capital gains rate for high-income taxpayers and the CIFA are on the table to help fund the Democrats' recently announced $3.5 trillion budget, below are a few things fund managers should be aware of.
First, in our view, it is unlikely that the long-term capital gains rate will be increased all the way to the ordinary income rate, even for high-income taxpayers. Given the 50-50 split in the Senate, Democrats would need the full support of the caucus in order to pass this legislation. While the capital gains rate may increase to 25% or 28%, Congress is unlikely to agree to such a dramatic change with respect to long-term capital gains. A modest capital gains rate increase would shrink the carried interest loophole – but would not eliminate it. Also, retaining a preferential rate for up to the first $1 million of gain may allow for planning opportunities by spreading out the recognition over a period of years.
Second, the CIFA does more than just turn carry allocations into ordinary income for fund managers – it has other important consequences. For example, the CIFA turns off the tax benefits under Section 1202 for fund managers (but not investors). In general, Section 1202 provides that gains from stock investments in small businesses (e.g., start-ups) held for 5+ years are exempt from tax up to the greater of $10 million or 10 times the investment amount. The exemption is applied on a per-taxpayer basis (not a per-fund basis), so each partner in the fund is entitled to his/her own exemption. Fund managers could still benefit from Section 1202 if Congress were to simply increase the capital gains rate consistent with Biden's campaign promise – but not if Congress enacts the CIFA.
Similarly, the CIFA turns off the general rule that assets can be distributed in kind from funds/partnerships without triggering gain or loss for holders of carried interests. Under the current partnership tax rules, if a portfolio company goes public, the fund generally can distribute the publicly traded stock out of the fund and let its partners (both the GPs and LPs) decide if/when to sell. If the CIFA is enacted into law, fund assets distributed in kind to the GP will be treated as taxable dispositions.
Finally, note that the CIFA applies only to interests in funds organized as partnerships (not corporations). Thus, in certain situations, consideration could be given to structuring the GP entity for a particular investment as a corporation instead of as a partnership, particularly if doing so would preserve eligibility for Section 1202.
The key takeaway is that an increase in the capital gains rate is not the same thing as the CIFA. Depending on what happens in Washington, DC this fall (and perhaps over the winter), funds should be consulting with their tax advisors to evaluate how to plan for big changes in the tax treatment of fund managers that seem likely to occur.