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Carried Interest Proposal Lacks Clarity and Revenue Impact

Posted on November 20, 2017 by Stephanie Cumings

A carried interest provision now included in both the Senate and House tax reform proposals lacks legislative clarity and isn’t likely to have much impact, practitioners told Tax Analysts November 17.

“Since this provision really won't necessitate a change in the way private equity sponsors do business, it makes you wonder why they bothered to insert the provision in the first place,” said Robert Willens of Robert Willens LLC. “Maybe the legislators simply wanted to be able to say that they ‘addressed’ carried interest, albeit in a way that will have very little, if any, impact.”

Monte A. Jackel of Akin Gump Strauss Hauer & Feld LLP said that the legislative language in the House bill (H.R. 1), which passed the house November 16, contains potentially problematic ambiguities that shouldn’t be left to technical corrections or regulations. Jackel said he was concerned lawmakers will rush to get a final bill approved without clarifying the legislative text.

The House’s proposal would impose a three-year holding period requirement for qualification as long-term capital gain with respect to some partnership interests received in connection with the performance of services. Senate Finance Committee Chair Orrin G. Hatch, R-Utah, issued a new manager’s amendment late November 16 that included a similar proposal, but without definitive legislative language. The Finance Committee approved its iteration of the tax reform bill, including the carried interest provision, the same day.

J. Rob Fowler of Baker Botts LLP said that current tax treatment has made some partnership interests as compensation “very popular.”

“Right now in the code, pursuant to some administrative grace from the IRS, there’s fairly favorable tax treatment for partnership interests that qualify as profits interest or carried interest, where if you hold the partnership interest for a year after you receive it and meet certain other requirements, the Service is not going to challenge the valuation of that interest, either at grant or at vesting, or attempt to make the recipient include an amount in income in connection with that arrangement,” Fowler said during a November 17 webcast hosted by Baker Botts.

Willens said that imposing a three-year holding period before long-term capital gains treatment can be enjoyed will not prove onerous to the private equity community since their investments are held for approximately six years on average. “These rules have no real effect on hedge fund managers since they rarely if ever hold securities long enough to enjoy the lower rates on long-term capital gain,” he said. “After all, hedge funds are traders whose holding period for securities is frequently measured in weeks, not years.” Jackel agreed that the proposal isn’t a dramatic attempt to change the taxation of carried interest — for example by taxing it as ordinary income rather than at the more favorable capital gains rate — and therefore there’s likely to be limited opposition from the industry. That limited impact is reflected in the revenue estimate, which the Joint Committee on Taxation put at only $1.2 billion over 10 years (JCX-54-17).

Legislative Ambiguities

Jackel said that the provision would apply where there is gain “with respect to” the applicable partnership interest. “Presumably, ‘with respect to’ encompasses allocations from the partnership of gains realized by the partnership, or a sale or redemption of a partner’s partnership interest,” he said. “This is not clearly stated in the provision.”

The provision also exempts partnership interests held by corporations, but Jackel questioned whether it was intended to be limited to C corporations or to include S corporations as well. Furthermore, partners can have split holding periods under reg. section 1.1223-3, and Jackel said those rules could taint the running of the three-year period under the bill.

Jackel said that the provision doesn’t apply to the extent the gain is attributable to capital commensurate with the capital contributed or the value under section 83, but he said the meaning of this isn’t clear. The provision says that section 83 does not apply to the transfer of the applicable partnership interest, he noted. “This takes the transfer of the interest out of section 83 and seems to render Revenue Procedures 93-27 and 2001-43 moot,” Jackel said. “Does this mean that the grant of such an interest is also excluded under section 61even if it was a capital interest?”