The timeline for the consummation of an equity-based transaction varies depending upon multiple factors that in part are beyond a seller’s control. However, fund managers have historically focused on ensuring that their carried interest allocation is subject to the more favorable long term capital gains tax rates by meeting the one-year holding period requirement under the Internal Revenue Code (“IRC”). As a result of the Tax Cuts and Jobs Act, passed into law on December 22, 2017, fund managers could find their carried interest allocations subject to tax at ordinary income tax rates rather than the more favorable capital gains tax rates.

Overview of Carried Interest Rules
Under the newly enacted IRC Section 1061 under the Tax Cuts and Jobs Act, a partner’s allocation of long term capital gain may be recharacterized as short-term capital gain, which is taxed as ordinary income rather than the more favorable long term capital gains rate. Based on the tax rates now in effect, capital gain allocations will be taxed at 23.8 percent (excluding state taxes) whereas ordinary income allocations will be taxed at a maximum rate of 40.8 percent (excluding state taxes).

In general, when a fund sells an asset (e.g., stock in a portfolio company), the gain on the sale will be treated as a capital gain. To the extent the disposed asset has been held for more than one year, the gain will be characterized as long-term and subject to the lower capital gains tax rate. However, if this gain is allocated to a partner holding an “applicable partnership interest” the gain will be recharacterized as short-term capital gain to the extent the disposed asset was held for less than 3-years. The newly enacted IRC Section 1061, therefore, creates a 3-year holding period with respect to certain assets instead of the 1-year holding period under the previous tax regime.

Under these new rules, the term applicable partnership interest means a profits interest issued by a partnership operating an “applicable trade or business” to a partner in connection with the performance of services. In other words, a carried interest received by a fund manager is an applicable partnership interest if the fund is operating an applicable trade or business. A fund that raises and returns capital in connection with investments in securities, commodities, rental or investment real estate, cash, options or derivative contracts with respect to securities, commodities, rental or investment real estate will be considered operating an applicable trade or business.

Here are some key takeaways:

  • As a result of the Tax Cuts and Jobs Act, fund managers could find their carried interest allocations subject to tax at ordinary income tax rates rather than the lower capital gains rates if held for under three years at the time of exit.
  • Properly tracking the holding period attributable to the disposed asset becomes critical and raises a significant trap for the unwary, especially when a fund (or its portfolio company) intends to grow through acquisitions.
  • This change in the required holding period and the potential for ordinary income taxation is causing fund managers to reassess the structure (and financing) of potential add-on investments, tax classification of portfolio companies, structure of monetization events, and the terms of their carried interest.
  • Fund managers should consider the potential pitfalls associated with their traditional structures to ensure the favorable long term capital gain treatment is obtained in current and future transactions.

Trap for the Unwary
The recently enacted IRC Section 1061 has caused fund managers to increase their focus on carried interest allocations and whether these allocations will result in long term capital gain. The key determining factor is whether the disposed asset has been held for at least 3-years. Accordingly, properly tracking the holding period attributable to the disposed asset becomes critical and raises a significant trap for the unwary, especially when a fund (or its portfolio company) intends to grow through acquisition or is classified as a flow-through entity (i.e., partnership) for U.S. income tax purposes.

This change in the required holding period and the potential for ordinary income taxation is causing fund managers to reassess the structure (and financing) of potential add-on investments, tax classification of portfolio companies, structure of monetization events, and the terms of their carried interest, including incremental interests granted under management fee waiver or cashless contribution arrangements.

Consider the following example:
Fund, LP raises $100M of capital with commitments of $1M to be contributed by the general partner (GP) and $99M to be contributed by the limited partners (LPs). Depending on overall performance of the fund, the GP will be entitled to an allocation of up to 20% of gains recognized on investment assets.

On 1/1/2017, Fund, LP invests $50M in the acquisition of a portfolio company (PortCo). Fund, LP invests additional capital in PortCo and contributes these funds to PortCo on several dates, including: 6/30/2017 ($10M), 12/31/2017 ($25M), and 3/31/2018 ($15M).

On July 1, 2020, Fund, LP sells the interest in PortCo for $175M recognizing long-term capital of $75M ($175M disposition proceeds less $100M total invested capital). Under the terms of the Fund, LP operating agreement, GP is allocated 20% of this gain, or $15M.

Of the $15M long-term capital gain allocated to the GP, $6M will be recharacterized as short-term capital gain calculated as follows:

  • Total long-term capital gain recognized by the fund equals $75M ($175M of proceeds less the $100M of total invested capital)
  • GPs share of this gain is $15M ($75M * 20 percent).
  • GPs share of gain recharacterized as short-term capital gain is $6M ($15M * 40 percent).

In order to minimize the amount of capital gain recharacterization, consider an alternative whereby PortCo obtained debt-financing on 12/31/2017 and 3/31/2018 instead of equity financing from Fund, LP. Structuring these subsequent investments as debt-financing would have prevented PortCo from issuing new stock to Fund, LP, which would have been a disposed asset with a holding period of less than 3-years. This change in financing structure for these investments would result in all of the carried interest allocation being subject to the more favorable long term capital gain tax rate.

Conclusion:
The enactment of IRC Section 1061 under the Tax Cut and Jobs Act extended the holding period needed to obtain the favorable long term capital gain tax rate. As fund managers assess additional opportunities to deploy capital or evaluate potential monetization events for a portfolio investment, the fund manager should consider the potential pitfalls associated with their traditional structures to ensure the favorable long term capital gain treatment is obtained in current and future transactions.

Jeffrey Bilsky is the technical practice leader for BDO’s national tax office partnership taxation group. Stephen Sonenshine is a partner in BDO’s transaction advisory services practice.


Jeffrey Bilsky

Jeffrey Bilsky

Jeffrey Bilsky is the technical practice leader for BDO’s national tax office partnership taxation group