For investment businesses—including many private equity, venture capital, real estate, and hedge fund partnerships—new rules governing the taxation of “carried interest” have been a source of concern for several years. The Tax Cut and Jobs Act of 2017 changed the way such income is to be reported and taxed, but 2022 is the first year in which the final regulations implementing those changes take full effect.

For several weeks during the summer, lawmakers considered a proposal to eliminate this so-called “loophole” as part of the Inflation Reduction Act of 2022. Ultimately, however, they dropped that provision, leaving the 2017 revisions in place. This means any business affected by the carried interest rules must now comply with new recordkeeping and reporting requirements that apply for the first time on 2022 tax returns.

Who’s Affected and What’s Changed

The term “carried interest” refers to the way investment fund managers are compensated. In addition to management fees, fund managers or general partners typically have a contractual right to share in the profits when underlying investment assets are disposed of. For years, the tax code has allowed fund managers to treat this carried interest as a long-term capital gain rather than ordinary income—making it subject to a lower tax rate—provided the assets had been held for at least one year.

The TCJA changed that, extending the holding period to qualify for long-term capital gain treatment from one year to three years. More specifically, the TCJA created a new IRC Section 1061, which requires that carried interest allocations for assets held less than three years be recharacterized as short-term capital gains and taxed at the higher ordinary income rate.

This requirement applies to any gains realized from an “applicable partnership interest” (API), which the statute defines as any interest in a partnership that is held by a taxpayer in connection with the “performance of substantial services” (rather than an interest resulting from the taxpayer’s investment). It also spells out specific “applicable trade or business” (ATB) activities that qualify as “substantial services,” such as raising or returning capital, as well as investing in, disposing of, identifying, or developing “specified assets.”

These specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, or any option or derivative of such assets. As a result, most private equity, venture capital, real estate, and hedge funds are now subject to Section 1061.

Exceptions to the New Requirements

Section 1061 identifies several exceptions to the three-year holding requirement. For example, a partnership interest held by a regular corporation (but not an S corporation) could be excluded. A partnership interest held by an employee of an entity that conducts non-ATB activities could also be excluded.

The statute provides fund managers who have also invested their own capital with a “capital interest exception” for a portion of their gains. This exception is subject to limitations related to the amount and timing of the taxpayer’s investment, the source of the funds that are invested, and various other details in the partnership agreement or management contract.

For real estate funds, long-term capital gains under IRC Section 1231 are also excluded from the three-year carried interest holding period. Section 1231 gains result from the sale of a trade or business property, including rental real estate. Note, however, there are limitations to this exception, and some common triple-net lease terms could prevent a property from qualifying for Section 1231 treatment.

The final implementing regulations for Section 1061 (https://www.govinfo.gov/content/pkg/FR-2021-01-19/pdf/2021-00427.pdf) encompass more than 40 pages of detailed provisions that identify additional exceptions and special situations, such as transferring partnership interests to related persons and “look through” rules for determining and reporting the appropriate holding period for various assets.

Despite this level of detail, however, certain questions remain unclear. These include the treatment of “carry waivers,” in which taxpayers waive their right to an API gain in favor of dividends or gains covered by other code provisions.

What Investment Businesses Should Do Now

Partnerships were required to begin reporting carried interest gains subject to Section 1061’s new three-year holding provisions with the 2018 tax year, but they did not receive detailed guidance on how to record and report this information until the IRS published its final implementing regulations in January 2021. In November 2021, the IRS released additional guidance (https://www.irs.gov/businesses/partnerships/section-1061-reporting-guidance-faqs), including worksheets that partnerships and individual taxpayers must use for calculating and reporting carried interest gains.

For calendar year filers, 2022 is the first tax year in which the new Section 1061 regulations—including their detailed bookkeeping and reporting requirements—are in full effect. Investment partnerships should review their recordkeeping and disclosure practices to ensure they are capturing and reporting all the information the new guidance requires.

In addition, if they have not done so already, they should review their partnership and management contract language to assess the possible tax consequences of the new carried interest provisions. Please reach out to Holbrook & Manter for more information on this topic. We would be happy to assist you.