The Tax Cuts and Jobs Act: Carried Interest Year-End Tax Considerations
On Friday, December 22, 2017, the President signed the Tax Cuts and Jobs Act (“Act”), containing the most sweeping tax changes in decades. Contained in the Act are changes to the treatment of “carried interests” which, depending on the trading strategy employed, may have a significant impact on alternative investment funds and their sponsors.
The Act introduces the concept of an “Applicable Partnership Interest” (API) which captures the carried interest, or profits interest, held by the general partner. The granting of a profits interest continues to be generally tax free under the new law. Prior to the signing of the Act, profits interest holders would benefit from long-term capital gain rates on dispositions of any capital assets held over one year. The Act now provides that holders of a profits interest will only be eligible for the preferential long-term capital gains rate with respect to gains realized on dispositions of capital assets, sold after December 31, 2017, held for more than three years. As it appears grandfathering of current profits interests will not apply, fund sponsors should consider the implications for profits interests currently held that will likely be treated as APIs.
Note that an API does not include an interest in a partnership directly or indirectly held by a corporation and it currently appears that such exception includes holdings by both C Corporations and S Corporations. Hopefully, there will be more clarity provided over the coming weeks, as it may be advantageous for certain general partners to convert their existing LLCs to S corporations, and such general partners may have until March 15, 2018 to accomplish such conversion in a tax-beneficial manner.
It is unclear under the new law, but investment returns associated with a general partner’s capital account balance may also be subject to the same three-year limitation as the carried interest itself. Accordingly, there may be various planning opportunities that general partners should consider prior to year-end, including:
It may be beneficial to sell appreciated positions prior to year end and recognize the gains in 2017.
- This will allow the fund to benefit from long-term capital gain rates on positions held over one year, and, as there will no longer be an ability to deduct state and local taxes (beyond the $10,000 limit) after 2017, potentially deduct the state and local taxes associated with those gains.
- Careful planning must be done to analyze all aspects of this, including Alternative Minimum Tax limitations and the tax rate changes in 2018.
Fund sponsors may wish to consider converting part of their general partner interest in the fund to a limited partner interest prior to year-end to separate their capital interest from what may be considered an API under the new law.
- At this point it is unclear if this strategy will be effective, as the new rules may trace the income in the LP account back to the carried interest and such gains may still be subject to the three-year rule.
Fund sponsors may also consider reducing the balance in the general partnership prior to year-end, by distributing securities in-kind to the general partnership. The general partner could then choose when to dispose of the securities based on holding period and when gain recognition is desired.
- Although not entirely clear, it appears the one-year holding period for long-term capital gain treatment should continue to apply to distributed securities.
What Does CohnReznick Think?
At this point, there is still a great deal of uncertainty on how the new carried interest regime will be applied, and further guidance from Treasury is needed to provide clarity in this area. However, taxpayers should ensure that they understand their various holdings and the new tax rules to ensure they timely formulate a strategy that is beneficial to them. If you have any questions regarding the taxation of carried interest, please contact your CohnReznick tax professional.
This has been prepared for informational purposes, is general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without first obtaining professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.