Partnerships, Part I: Carried interest and the loophole

How carried interest works -- and the rules before and after the 2017 Tax Cuts and Jobs Act

By: Carl Breedlove  /  April 17, 2018

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Author’s note: This series will take a close look at partnership issues, including carried interest, net operating losses and audit procedures. In Part 1 of this series below, we’ll explain how carried interest works and what the “loophole” is. In Part 2, we’ll explain the new net operating loss rules and how they could impact partnerships. Finally, in Part 3, we’ll explain the new partnership audit procedures that went into effect Jan. 1.

During the past three presidential elections, carried interest has been a major talking point among candidates and pundits alike. But what exactly is carried interest, and how does it work?

In a typical partnership, a partner’s interest in the profits is proportional to the partner’s capital contributions to the business, including cash and non-cash assets.

Carried interest is different in that the interest holder receives a share of profits that’s more than the proportion of his or her contributions to the partnership. Partners use this type of interest when they anticipate performing significant services for the partnership, and they trade a salary or accept a reduced salary for an increased share of profits.

How carried interest works

Suppose John, Jane, and Bob want to form the JJB hedge fund that they will run as a partnership. John contributes $100,000, Jane contributes an office building worth $90,000, and Bob contributes $10,000.

Bob agrees to do a lot of the work to get the fund going, while John and Jane will perform minimal services. The partners agree that John and Jane will each receive a 40% interest, and Bob will receive a 20% interest.

If the partners considered only the capital contributions, John should get a 50% interest, Jane should get a 45% interest, and Bob should get a 5% interest in partnership profits. But rarely do partners look at capital in a vacuum when making these decisions.

So, Bob’s interest will be classified as “carried interest,” because he is getting an interest percentage that’s more than the proportion of capital he contributed.

Partnerships often use carried interest arrangements to acquire talented people who don’t have capital to contribute.

So, what’s the loophole?

Ordinarily, when taxpayers receive compensation for services, that compensation is taxed as ordinary income. But carried interest may be a strategy used to compensate partners at long-term capital gain rates. If the interest comes from the sale of capital assets (which is common in finance, private equity, and hedge funds), it may be taxed at the preferential long-term capital gains rate, provided the partner holds his or her interest for a minimum period of time.

Because long-term capital gains rates are lower than ordinary or short-term capital gains rates, the carried interest generates a lower tax liability compared to regular compensation.

Enter, the Tax Cuts and Jobs Act

In response to this loophole, Congress added a provision in the 2017 Tax Cuts and Jobs Act (TCJA).

For tax years beginning after Dec. 31, 2017, a carried interest holder will get the preferential long-term capital gains rate only if he or she held the interest for at least three years before receiving the income. The prior law required only a one-year holding period.

So, if the partner hasn’t held the carried interest for at least three years, the income that flows through will be taxed at the less favorable short-term capital gains rate.

Going back to the example above, assume JJB receives $350,000 of income from capital sales in year two and $350,000 in year four. Bob’s share of the income would be $70,000 for year two and year four since he has a 20% share of profits.

Under prior law, all Bob’s income in both years would be taxed at the long-term capital gains rate, which results in federal tax of $2,910 (allowing for a standard deduction of $12,000) for each year.

Under the TCJA, Bob’s $70,000 share of income for year two is taxed as ordinary income because he has held the interest for only two years. Assuming Bob is single, his marginal tax rate would be 22% for year two, resulting in federal tax of $6,148 (allowing for a standard deduction of $12,000 and the qualified business income deduction).

Bob would get to use the long-term capital gains rates in year four, because he would have held the interest for at least three years at that point. Therefore, Bob would see an increase of $3,238 in his tax bill for year two under the TCJA.

S corporations are also subject to the rule

In response to this TCJA change, some taxpayers considered transferring their carried interest to S corporations in which they are the sole shareholder. Theoretically, this strategy maintains capital gains treatment when the income eventually flows through to the shareholder, because the new law originally excluded corporations from this special holding-period requirement.

However, the IRS responded by issuing Notice 2018-18, which states that the three-year holding period also applies to S corporations, because, like partnerships, S corporations are pass-through entities. The notice also states that forthcoming regulations will explain more.

In Part Two of this series, we’ll explain the new rules for deducting net operating losses and how they affect partnerships.

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Carl Breedlove

Carl Breedlove is a tax research analyst at The Tax Institute. Carl works with a research team focused on tax law and policy, including analysis of the Tax Cuts & Jobs Act, state law updates and IRS materials.

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