The taxability of a “carried interest” has been subject to much debate. A “carried interest” is a term of art used to refer to the receipt of a profits interest, a popular structure in entities taxed as partnerships with private equity, hedge fund, and real estate investors. Under the law that existed prior to the act passed in December 2017 (the “2017 Tax Act”), carried interests were typically taxed at long term capital gains rates (23.8% if you include the 3.8% Medicare surtax), assuming the recipient held the carried interest for a year or longer.
Many commentators have long argued that a carried interest is essentially compensation and should be taxed as ordinary income (up to 40.8% if you include the 3.8% Medicare surtax). New Section 1061, enacted as part of the 2017 Tax Act, extends the required holding period for “applicable partnership investments” (i.e., carried interest) to qualify for long term capital gains treatment (again 23.8%) from one year to three years.
Note that an “applicable partnership interest” is defined in Section 1061(c)(1) as a partnership interest that is transferred to a taxpayer in connection with the performance of substantial services (a carried interest), but per Section 1061 (c)(4)(A) does not include any interest in a partnership directly or indirectly held by a corporation. Following enactment of the 2017 Tax Act, some practitioners commented that if the term “corporation” included an S corporation, service providers could structure a receipt of a carried interest to be held by an S corporation and avoid the 3-year limitation of Section 1061. On March 1, the IRS issued Notice 2018-18, which clarifies this issue and provides that the IRS will issue regulations providing that the term “corporation” for purposes of Section 1061(c)(4)(A) does not include an S corporation. The regulations, just like Section 1061, will be effective for taxable years beginning after December 31, 2017.
Authored byRandall D. McClanahan