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How New IRC § 1061 Impacts Carried Interests

How New IRC § 1061 Impacts Carried Interests

During the past decade, the White House, Congress and the IRS have threatened on numerous occasions to reduce or eliminate the tax benefits of carried interests ("promotes" in the real estate world). In 2009, legislation was introduced that would have taxed all income from carried interests as ordinary income.

That proposed bill and similar efforts in later years failed in the face of strong opposition. The 2017 Congress took a moderate approach to scaling back the benefits of a carried interest. IRC § 1061 increases the holding period required for long-term capital gains treatment from more than one year to more than three years for an "applicable partnership interest." Although this provision won't affect many holders of incentive equity, professionals who work in the hedge fund, private equity or real estate industries will need to keep IRC § 1061 in mind when structuring their compensation arrangements.IRC § 1061 doesn't change the basic favorable treatment of carried interests or other grants of profits interests. Profits interests, including carried interests, continue to be nontaxable at the time of issuance. Subject to the new three-year holding period under IRC § 1061, the holder of a carried interest continues to enjoy long-term capital gains treatment (not subject to employment taxes) from the sale of partnership assets, or the sale or redemption of the carried interest.

Prior to the enactment of IRC § 1061, a hedge fund professional might be issued a carried interest on Tuesday and a day later share in an allocation of long-term capital gains if the partnership sold a capital asset held for more than a year. The same hedge fund manager could sell his interest after a year and claim long-term capital gains treatment (subject to ordinary income for "hot assets" under IRC § 751 and perhaps sweating the impact of Revenue Procedure 93-27's two-year holding period requirement). Today, this same hedge fund professional would have short-term capital gains on the sale of both the partnership's capital asset and his carried interest.

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J. Aaron Byrd is FBT’s Estate Planning Team leader and counsels on probate, trust administration, business succession, and asset protection planning, as well as gift, wealth transfer and generation-skipping taxation issues.