Carried Interest Holding Periods

Carried Interest Holding Periods

Charles C. Shulman, Esq.
Teaneck, NJ, 201-357-0577
cshulman@ebeclaw.com

 As discussed in my earlier post on Profits Interest at https://ebeclaw.blogspot.com/2022/03/profits-interests.html , profits interests have become an increasingly popular type of equity-based award if the entity is taxed as a partnership, as they avoid income tax or FICA tax on grant and vesting, and yield long-term capital gains on sale if certain requirements are met. However, in 2017 this was limited in the case of profits interests (carried interest) for professional investors and real estate development for rental or investment to where the holding period is three years. A 2020 legislative proposal in the pending Inflation Reduction Act to increase the holding period for such carried interest from three years to five years and to only begin only once substantially all the partnership interest subject to IRC § 1061 are acquired by the partnership. However, in further negotiations this proposal was taken out of the final bill. 

Pre-2017 Holding Period for Profits Interests – Two Years from Grant and One Year from Vesting. Prior to the enactment of the Tax Cuts & Jobs Act of 2017, generally long-term capital gain treatment for profits interest would require the general one-year holding period requirement (from the date the profits interests are vested). In addition, Rev. Proc. 93-27 would require that the profits interests be held for at least two-years after the date of grant.

Extended Holding Period for Professional Investors and Real Estate Investment to Three Years Under TCJA of 2017. Legislative changes imposed by the Tax Cuts & Jobs Act of 2017 (effective January 1, 2018) enacted a new IRC § 1061, which imposes a three-year holding period (instead of one year for ordinary capital gains) for an "applicable trade or business," if the partnership owns real estate for rental or investments, since IRC § 1061, enacted by the Tax Cuts & Jobs Act of 2017 and effective in 2018, in an effort to clamp down on "carried interest" use of long-term capital gains tax rates for fund managers, provides that "applicable partnership interests" which includes professional investors as well as those developing real estate for rental or investment (IRC § 1061(c)(2)), have an increased holding period for long-term capital gains treatment for three years instead of one year. IRC § 1061(a).

2022 Proposed Legislation to Further Extend Holding Period for Such Carried Interest to Five Years, was Removed from the Bill to Win Approval from Sen. Krysten Sinema. Further legislative changes had been proposed in the Inflation Reduction Act in July 2022, H.R. 5376, as agreed to by Senator Charles Schumer and Senator Joe Manchin to amend IRC § 1061 in the following ways: (i) the holding period for "applicable partnership interests" which, under IRC § 1061(c)(2), includes carried interest for professional investors (e.g., private equity firms and hedge funds) and real estate development for rental or investment, would be increased from three years to five years (except with respect to taxpayers with adjusted gross income of less than $400,000); (ii) the five-year holding period would begin only once substantially all the partnership interest subject to § 1061 are acquired by the partnership; and (iii) the holding period would now apply not just to profits interest but also to other income taxed as long-term capital gains, including qualified dividend income included in net capital gain for purposes of IRC § 1(h)(11), gain from the sale of active business assets under IRC § 1231 and regulated futures contracts subject to IRC § 1256. However, it has now been reported on August 4, 2022 that Democrats are revising their Inflation Reduction Act in order to will approval from Senator Kyrsten Sinema (D. Arizona), which, among other things, would drop the proposed tax increase on carried-interest income. However, the carried interest tax change may appear in future legislation.

If you have any questions, please contact me at cshulman@ebeclaw.com or 201-357-0577.