The House Ways and Means Committee has adopted Chairman Kevin Brady’s (R-TX) amendments to the House tax bill containing a provision addressing “carried interest.”  “Carried interest” is the term commonly used for an equity interest in a partnership that entitles the holder to a share of the partnership’s profits that is larger than the holder’s percentage interest in the capital invested in the partnership.  Under current law, a carried interest is treated in the same manner as any other partnership interest, with the result that the character of the income and gains recognized by the partnership (e.g., as long-term capital gain, short-term capital gain or ordinary income) flows through to the partner.

For more on the taxation of carried interest under current law you can read our primer on the basics.  We also previously covered potential reforms to the treatment of carried interest.  Below is a summary of the proposal.

Three-year holding period. The amended bill would generally require an investment partnership to hold an investment for more than three years in order for carried interest allocations of gain from the sale or disposition of that investment to qualify for reduced rates applicable to long-term capital gains.  Any carried interest allocations consisting of capital gains from investments that did not meet the three-year holding period requirement would be treated as short-term capital gains, which are taxed at the rates applicable to ordinary income.

Limited to “applicable partnership interests. The special three-year holding period requirement applies only to capital gain derived by the taxpayer with respect to an “applicable partnership interest.” An “applicable partnership interest” is a partnership interest that is transferred to, or held by, a taxpayer in connection with the taxpayer’s (or a person related to the taxpayer) performance of substantial services in an “applicable trade or business.”

  • An “applicable trade or business” is generally defined to mean (i) raising and returning capital and (ii) either investment or development activities with respect to “specified assets.”
  • “Specified assets” are (i) securities, commodities, real estate held for rental or investment and cash or cash equivalents and (ii) options or derivative contracts with respect to, and interests in partnerships relating to, any of these assets.
  • The proposed provision provides no guidance as to what will constitute “substantial services.”

The bill does not include the requirement under current IRS guidance that the holder of the profits interest provide those services to or for the benefit of the issuing partnership “in a partner capacity.” It is not clear whether this IRS guidance would continue to apply if the proposed legislation were enacted.

Qualified dividend income unaffected.  Carried interest allocations of “qualified dividend income” (generally, dividends from U.S. corporations and certain non-U.S. corporations) would continue to qualify for the 20% rate without regard to the three-year holding period requirement under the provision.

Sale of carried interest.  The three-year holding period requirement would also apply to gain derived by a taxpayer from the sale or disposition of an interest in a partnership that entitled the taxpayer to receive carried interest allocations. In this situation, the taxpayer would be required to have held the partnership interest for more than three years in order for the gain on the disposition to qualify for long-term capital gain rates.

Related party transfers.  Although not entirely clear, a special rule appears to treat a direct or indirect transfer of a carried interest to certain specified persons as a taxable sale of the carried interest, even if the transfer would otherwise be entitled to non-recognition under another provision of the Internal Revenue Code.  The specified persons are (i) any family member or (ii) any person who performed services in the current year or the preceding three years in any “applicable trade or business” in or for which the taxpayer performed a service.

Grant of carried interest not subject to Section 83. The bill provides that Section 83 does not apply to a grant of an “applicable partnership interest.”  As a consequence, in order to support the position that the grant of carried interest is not a taxable event, a recipient of carried interest would not be entitled to make a “protective” Section 83(b) election with respect to such interest and instead would be required to rely solely on IRS guidance with respect to partnership profits interests.

Exception for interests in partnership capital. Under the provision, an “applicable partnership interest” does not include a partnership interest that provides the taxpayer with a right to share in partnership capital commensurate with either (i) capital contributions actually made by the taxpayer or (ii) amounts that were included as compensation income by the taxpayer at the time of grant or vesting of the relevant partnership interest.  A grant of such an interest would still be subject to Section 83 under the provision.

Exclusions for certain service providers. The provision provides that the three-year holding period requirement would not apply to a partnership interest held by a person who is employed by another entity that conducts a trade or business (other than an “applicable trade or business”) if such person provides services only to that other entity. Although not entirely clear, this provision may have been intended to clarify that the three-year holding period requirement does not apply to executives of a portfolio company who hold profits interests in a holding vehicle for the portfolio company.

Not subject to self-employment tax.  Unlike prior proposals on carried interest, the provision would not subject gains from investments held less than 3 years to the self-employment tax.  However, such gain could be subject to the Medicare tax on net investment income.