Perspectives on Carried Interest
By: Molly Jones, CPA
The past decade has seen a tumultuous amount of changes in the tax law. It should continue to be noted that prior to the Tax Cuts and Jobs Act of 2017, the last major overhaul of the tax code was in 1986. Thus, tax professionals have spent nearly 30 years navigating those changes by leveraging case law and other substantiative authorities. Furthermore, tax laws tend to leave out, or miss, important details that are later followed up with seemingly, clarifying points. Most importantly, from a taxpayer perspective, this phase of constant change continues to develop and tax laws remain in flux, resulting in an impact to tax strategy that continues to evolve.
Looking at the discussion around carried interest rules in recent years, this is one area that continues to be at the forefront of fiscal policy. Most recently, there was talk of removing carried interest altogether. This language was eventually removed and not included with the passing of the Inflation Reduction Act of 2022. It is important for us to remind ourselves of what these rules are from a tax perspective and understand the treatment under current tax law. Doing so, will help us be ready for other changes that may come surrounding these rules.
A “carried interest” is a type of profits interest whereby those who hold such interest are allocated profits from generally private equity, hedge, or venture capital funds. The interest in the partnership is given in exchange for services to be performed. Following a targeted capital income allocation, once carry is triggered, the profits interest member is allocated gains. Typically, these are capital gains as carry is often triggered upon a liquidation event. The tax law provides that income allocated to a profits interest member is given the same treatment – ordinary or capital for instance – as to a capital interest member. So long as certain measures are taken to protect one’s profits interest, capital gain treatment will be honored by the tax law.
However, there was a significant change to the carried interest rules with the passing of the Tax Cuts and Jobs Act of 2017. It essentially provided gains allocated under carry, specially to a member holding an “applicable partnership interest” as defined in Internal Revenue Code §1061 – generally a “carried interest” – would be subject to ordinary income tax rates if the underlying assets that generated the income were held 3 years or less. In other words, it moved the holding period of assets liquidated from 1 to 3 years to receive capital gain treatment.
Discussions around the carried interest rules come up every year. Again, it is important to reflect on the current treatment of income allocated to a profits interest holding so that we can be better prepared for the impact on those taxpayers to which it applies.
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Craig Arends is a principal at CLA and is the managing principal of CLA's private equity practice. Craig brings a concentration of experience in providing accounting and transaction structuring advice for leveraged recapitalizations, purchase accounting and SEC reporting, assessing quality of earnings, and GAAP accounting. He has far-reaching experience with critiquing financial models and reviewing target companies' financial performance to identify cost reductions and/or operating efficiencies Craig has more than 30 years of experience in public accounting serving public companies, private equity groups, and companies, including a term as principal in charge of a Big Four Capital Markets Group in Moscow, Russia. He has led financial accounting due diligence projects for private equity investor groups and venture capital funds, primarily in the technology, communications, and manufacturing industries, as well as assisting with Foreign Corrupt Practice Act matters ranging from investigation of payments made, validation of compliance with corporate policies, and review of proposed transactions to ensure compliance. When not working, Craig enjoys watching any sports, but his most favorite are baseball, football and soccer.
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