The IRS released proposed rules to clarify the treatment of carried interests, provisions that put restrictions on how much investment related income can qualify for a lower tax rate. The expansive proposed regulations released on July 31 provide some additional application and implementation guidance for private equity and venture capital fund managers to the carried interest regulations enacted by the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA).

The TCJA increased the length of time that owners of pass-through entities must hold a carried interest investment before any “carry gains” from the sale of that investment becomes eligible for the long-term capital gains tax rate. The TCJA bumped the holding period up from one to three years. If owners of pass-through entities hold investments for shorter holding periods, any gains related to carry will be treated as short-term capital gains tax subject to ordinary tax rates. Depending on an individual investor’s tax bracket, the short-term capital gains tax rates could be significantly higher than the long-term capital gains tax rate. The long-term effective capital gains tax rate tops out at 23.8%, whereas the maximum marginal tax rate is 37%.

Next Steps

The volume of updates contained in the proposed regulations on carried interest will take some time to process and analyze. Among its many provisions, the proposed regulations confirm that owners of S corporations with carried interests held by the S corporation will remain subject to the carried interest provisions. The proposed regulations also clarify that Section 1231 gains allocated by pass-through entities are not subject to higher tax rates, which is of critical importance to real estate industries. Final carried interest regulations are not expected anytime soon. In the meantime, pass-through entities, particularly in the investment management and private equity space, may continue to apply the carried interest limitation as it is worded in the TCJA.

Our team is reviewing the proposed regulations and will provide you with more insight as well as offer a webinar on this topic in the coming weeks. We will continue to monitor for updates and further clarifications around the carried interest rules. For more information about how the proposed regulations would affect your organization, please contact us.

Published on July 31, 2020