One provision of the Tax Cuts and Jobs Act that may influence your choice of investments is the new rule on the taxation of “carried interest.” Understanding the impact of carried interest is critical when forming, managing or investing in private equity, venture capital, real estate or other similar investment funds.
What is Carried Interest?
A “carried interest”, also known as a “promote interest”, is a share of a private equity fund’s profits that a general partner is allocated regardless of his/her capital investment in the fund. General partners typically do not represent a significant portion of a fund’s total capital investment, with most capital being funded by outside investors as limited partners. Carried interest provides a mechanism where a general partner is allocated a share of the fund’s profits disproportionate to its capital investment in the fund. Put more simply, carried interest can be interpreted as “compensation” paid to a fund manager for motivating them to maximize the fund’s performance and investment returns. General partners typically will receive the carried interest only after a certain minimum investment return is allocated to all partners in the fund based upon their proportionate capital investment.
Controversy of Carried Interest Taxation
Taxation of carried interest has been a hot button topic due to the ability of general partners to treat carried interest as long-term capital gains, resulting in lower taxes paid on this income. The debate arises because long-term capital gain treatment is typically reserved for investment income. Although the general partner has a minor investment in the fund, the income received as carried interest is disproportionate to their capital investment leading some to argue that it should be taxed as ordinary income they are receiving in return for their services they provide to the fund.
Although the Tax Cuts and Jobs Act recently altered the tax rules of carried interest, the treatment as long-term capital gains are still available.
Recent Changes to Carried Interest Taxation
Historically, the treatment of carried interest as long-term capital gains has been available if the fund held the assets for greater than one year. The Tax Cuts and Jobs Act modified the taxation of carried interest, however, still allowing long-term capital gain treatment, but increasing the holding period to three years. It should be noted that Massachusetts has not adopted the new federal holding period. It retains the one-year holding period to determine whether the carried interest is eligible for long term gain treatment.
The LGA team is ready to step in and help you get a better understanding of how these complicated investments work and provide you accounting and tax advice whether you are the investor or the manager/general partner in these investment vehicles.
Contact Steve Gallant (Tax) and Matt Touma (Accounting) for more information.