Carried interest tax treatment: Green Book proposed changes

On May 28, 2021, the Biden administration released its fiscal year 2022 budget. Detailed descriptions of the Administration’s tax proposals were provided in the Treasury Green Book.

As part of their proposals, the administration addressed the beneficial treatment of “Carried Interest” in current tax legislation, which allows partnership profit interests received in exchange for services provided to receive a share of long-term capital gains which are taxed at reduced rates.

Rationale for the Changes

In the Green Book, the Administration argues that a partnership interest received in exchange for the performance of services is, in essence, a form of compensation and the resulting income should be treated as such. The “carried interest loophole,” which has provided favorable tax treatment to managers of private equity and investment funds, has long been viewed as an unfair advantage for these taxpayers.

Proposed Changes

The Green Book proposes that a partner’s share of income in an “investment services partnership interest” (ISPI) would be taxed as ordinary income and subject to self-employment tax, regardless of the character of income at the partnership level, if the partner’s taxable income from all sources exceeds $400,000. The sale of an ISPI would also be treated as ordinary income, rather than capital gains, to further avoid preferential tax treatment.

The Green Book defines an ISPI as a profits interest held by a person providing services to the investment partnership. An investment partnership is defined as one with substantially investment-type assets (certain securities, real estate, interests in partnerships, commodities, cash or cash-equivalents, and derivative contracts), if more than half of the partnership’s capital is from partners for which the interest would not constitute a trade or business.

Proposed Exceptions

  • Capital (Invested) Interest Exception – If the carried interest partner contributed capital (not through a loan from the partnership or a partner) and is allocated income to their invested capital, commensurate with allocations to the capital contributed by the other partners, then income attributable to the carried interest partner’s invested capital will not be recharacterized.
  • Trade or Business Exception – If 50%, or more, of the capital contributed to a partnership is from partners that hold the partnership interest in connection with a trade or business, then these rules would not apply to the partnership.

The Green Book also includes an anti-abuse rule for “disqualified interests” which are convertible/contingent debt instruments, options, or any derivative instrument received by a person performing services for the partnership. In essence, this prevents carried interest arrangements with other instruments besides partnership interests.

The proposed changes would be effective for taxable years beginning after December 31st, 2021.

Mazars’ Insight

The proposed changes would significantly affect fund managers and employees of private equity firms that use current carried interest rules for additional performance compensation at favorable tax rates. Based on the proposed rules, there are planning opportunities available such as structuring the investment company’s capital contributions in a manner which would be considered part of the “trade or business” of the partners, or including carried interest partners directly into operating partnerships instead of in investment partnerships.

Please contact your Mazars professional for additional information.

Published on June 9, 2021

Authored by Alexander DeRienzo and Joel Unger