Carried Interest Rules Prompt Investment Funds to Rethink Plans

Hedge funds and private equity managers will have to rethink strategies to shield some of their pay from higher taxes following IRS rules for carried interest.

The 2017 tax law changed the way carried interest, the portion of an investment fund’s returns that are paid to managers, is taxed. The law requires the funds to hold assets for more than three years—up from one—for managers to get a preferential tax rate of 20% versus 37%, generally accompanied by an additional 3.8% net investment income tax.

Some funds altered their partnership agreements to structure carried interests in a way that would potentially circumvent the new holding period under tax code Section 1061, said Robert Richardt, a tax partner at CohnReznick LLP.

Now that the IRS has issued proposed regulations, “you have to go back and say, ‘OK, what sort of planning did you do post-enactment of the Tax Cuts and Jobs Act under 1061?,’” he said, referencing the tax law. “And then you have to really take a look at what the regs say, and see if that changes anything that’s happened from two and a half years ago,” he said.

Carried interest waivers are one aspect of agreements funds may want to revisit, attorneys said. These waivers allow a manager to waive short-term capital gain in exchange for a larger share of future gain.

Some funds structured the waivers in a way that allows managers to waive gains from investments sold off in under three years, but recoup those amounts out of gains from investments disposed of after three years. The IRS in the Friday rules (REG-107213-18; RIN 1545-BO81) directly addresses this strategy, warning that “taxpayers should be aware that these and similar arrangements may not be respected and may be challenged.”

The cautionary note will likely prompt funds to consider adjusting their agreements in a way that allows managers to benefit only from future appreciation after the date of the carried interest waiver, said Alexander Anderson, a partner at O’Melveny & Myers LLP. They may also want to give themselves authority to modify the waiver provision to comply with any future IRS guidance, he said.

“That is, I think, the primary change that we probably will see,” he said.

S Corp Workaround

The 2017 tax law exempted corporations from the longer three-year holding period.

Some funds read that language as including S corporations—a type of pass-through entity in which income flows through and is taxed at the individual shareholder level, as opposed to the entity level like a C corporation.

But the IRS indicated in the proposed rules that it intends to block any workarounds involving S corporations or passive foreign investment companies. It foreshadowed this stance in a 2018 notice.

Even so, a few private equity and hedge funds converted their management companies from partnerships to S corporations after the passage of the 2017 tax law in the hopes that S corporations would be eligible for the exemption, said Jerry Musi, a tax partner specializing in private equity funds at RSM US LLP.

“I didn’t see much of it because people were just afraid,” Musi said. But the ones that did now have to consider reconverting, he said, noting that partnerships are a lot more flexible than S corporations.

Capital Interests

Investment fund managers may also have to reconsider how they’ve structured their capital interests.

If managers invest their own money in the fund, the gains from those investments generally aren’t subject to the carried interest limitations.

The regulations take a narrow reading of the exception to prevent managers from converting their carried interests into capital interests, said David H. Schnabel, head of the Tax Department at Davis Polk & Wardwell LLP.

He called the regulatory approach “very mechanical,” saying the rules “essentially require that everything be pro rata in order to qualify for that exception.”

But there are many situations where that’s not the case for economic, rather than tax, reasons, he said.

That “may cause capital interests to foot fault their way out of that exception,” Schnabel said.