Tax Optimization of Carried Interest for Fund Managers

Fund managers across the board, whether securities, commodities, cryptocurrencies, real estate, venture capital biotechnology or oil and gas, largely depend upon their carried interest in the fund where investment assets are housed in a partnership.  Carried interest (this is the industry term for “incentive allocation of profits”) represents a share of partnership profits that is not based on the manager’s own capital account interest in the fund. Carried interests can be subject to various contractual limitations, including an extended measuring period which can be as long as 36 months (i.e., the manger’s entitlement to the carried interest is based on the most recent 36 months’ results of the fund) as well as the “high water mark” (i.e., if an investor has a bad result for one period the manager is not entitled to the carried interest until that negative return is brought back to the capital account prior to the bad period).

For years, there have been many proposals and proposed legislation coming out of Congress to either kill the carried interest or cut it back substantially. The complaints were that the carried interest was, in economic terms, a form of compensation and should be taxed as such. This would have meant that the carried interest would not be made up of capital gains, including long-term capital gains where realized by the fund and also self-employment income for active members of the managers. Their proposals, if they had been enacted, would have resulted in a very substantial increase in the effective tax federal personal income rate of fund managers, from a rate as low as 20 percent, where all of the carried interest was long-term capital gain, to as much as 40 percent or more.

And then it happened. The Tax Cuts and Jobs Act of 2017 enacted Section 1061 of the Internal Revenue Code, containing many anti-manager provisions, often inartfully drafted. To summarize Section 1061, the carried interest is treated as short-term capital gain unless the fund’s holding period for that asset was over three years.

After much confusion during the regulations’ drafting process, the manager’s own capital account (that is, capital contributed by the manager) is exempt under the final regulations from the three-year holding period as long as the contractual terms applicable to the manager’s capital account are similar to the provisions applicable to the investors’ partnership interests.  The final regulations are far more useful than the proposed regulations and the text of the statute itself, which led many tax advisors to counsel their clients to house the manager’s own capital account in a separate entity.

Section 1061 has its fair share of quirks. For example, Section 1256 commodities contracts (known as “60/40” contracts because 60 percent of gain or loss is long-term and 40 percent is short-term, regardless of holding period) are exempt from the three-year rule.

Working with Section 1061 leads to certain paths. The three-year holding period was apparently intended to exclude private equity and biotechnology funds, as well as any classes of investment funds that turn over their assets very infrequently. There is nothing in Section 1061 or its rather sparse legislative history that addresses this very valuable exclusion. The revision of fund documents to address the location of the fund manager’s own capital account should be addressed presently, if it has not already been addressed. Further tax projections for the manager’s own personnel must be modified, if they have not already been, to reflect the application of the three-year holding period rule to the fund’s realized gains.

What has emerged as a very worthwhile tax optimization strategy is a review of the holding periods of fund assets where a three-year holding period for at least some substantial portion of the assets’ value is feasible. For those fund managers whose concept of a long holding period is a week, this strategy will be inapplicable. As always, when looking at capital losses, you usually want to dispose of them before a one-year holding period is met, just as with capital gains you want to meet the one-year-and-a-day holding period for long-term capital gains. The Section 1061 optimization is based on whether the three-year holding period for appreciated assets can be met.

EXAMPLE. Securities Partnership Delta, LP owns many securities lots, including 20,000 Symbol AAA bought two years and ten months prior for $20.50 per share and 20,000 AAA bought one year prior at $21.50 per share. AAA is now at $47.12. If the manager decides to sell the older AAA lot, then the three-year period would be met in two months, but the second lot has over two years to attain the three-year holding period. Assuming that the manager’s duties to the investors would not be negatively affected by waiting the two months, the manager would achieve a substantial tax savings by the elapse of the two months.

Enter President Biden

As unpleasant as Section 1061 may be to many fund managers, conditions would get a lot worse if President Biden’s tax proposals are enacted. Tax proposals from the administration are termed the “Green Book” because of the (unattractive) green colored cover when the proposals are contained in a physical book.  At the time of preparing this article, the President’s tax proposals are just that – brief, vague descriptive language without bill language.  Washington tax lobbyists have pointed out that tax proposals in the Green Book (such as those from Presidents Clinton and Obama) are often vague, and it is not until the proposals are put in bill language, if ever, that we have something concrete to parse.

So, while waiting for bill language to appear (hopefully, never), Mr. Biden’s tax proposals can be summarized as follows. First, all carried interest amounts would be taxed as ordinary income.  Thus, the three-year rule in Section 1061 would vanish. Further, all fund management personnel that actively work on the fund management would be hit with self-employment income. This would apparently include not just managers structured as partnerships but S corporation shareholders as well. This proposal, if enacted into law, would effectively terminate all advantages of the carried interest, apparently for all fund managers.

If we reach the bill language stage, we will expect to see revenue forecasts. The part on carried interest proposals, in order to generate substantial revenue forecasts, would have to include all the industries where the carried interest is employed, particularly real estate. If the revenue forecast is very substantial, then we can expect vigorous lobbying on behalf of all industries affected. It is said by Washington tax lobbyists that the costs of lobbying to repeal a provision that is already enacted into law is some three times the cost of heading it off before enactment.  We shall see.

Hope for the Future

First, we can hope that President Biden’s carried interest tax proposal is not enacted into law. The tax proposals are very broad, controversial and we may hope that they will collapse of their own weight.

Second, if the President’s tax proposals are enacted into law, there would be one obvious strategy to deal with it, based upon current law. That is, the carried interest is measured by a three-year measuring period, so that the carried interest is not due until the end of the three-year period. This is not an uncommon provision today. Then, before the end of the three year period the manager sells its interest in the management company to an institutional manager, receiving the proceeds in whole or in major part as long-term capital gain. Sales to institutional managers are not uncommon in the industry.

What if the manager wants to retain management interest in the fund? Apart from reducing state and local income taxes (e.g., move to Florida, Nevada, or Puerto Rico), there is not much one can do in light of the sweeping nature of the President’s tax proposals.

This article was originally published in the August 31, 2021 issue of HFM Global.