Maximizing the Value of your Carried Interest
After the passage of the 2017 Tax Cuts and Jobs Act (ACT), many people are wondering how to maximize the value of their carried interest. There are some changes in the ACT that might affect how you proceed when selling or transferring your carried interest to achieve long-term capital gain treatment. These rules apply to taxable years ending after December 31, 2017.
NEW THREE-YEAR HOLDING RULE
Perhaps you’ve heard of the new three-year holding rule but you’re not sure if it applies to you.
Distributions and gains passed thru to you because of your carried interest
To receive long term capital gain rates (20%) on gains or distributions associated with your carried interest from the fund, the underlying investment at the fund level must be held for more than three years.
Sale or redemption of your Carried interest
If you decide to redeem or sell a portion or all your carried interest, your interest must be held for more than three years to get the long-term capital gain rate treatment.
Additional guidance from the IRS is needed to see if the underlying investments at the fund level must also be considered when you sell or redeem your interest.
Planning Point: The good news is that if stock is distributed to you and it has not yet met the three-year requirement, you can use the fund’s purchase date of the stock and hold on to it until it satisfies the three-year requirement to achieve long-term capital gain rates.
TRANSFERS OF CARRIED INTEREST-HIDDEN TAXABLE EVENT
Prior to the ACT, when you gifted your carried interest to a non-charity, typically your accountant would inform you that you may incur some gift taxes or if the proper structure was in place, no gift taxes at all.
Now, with the passages of the new ACT, you may get a call from your accountant asking you to not only pay gift taxes, but income taxes as well.
What? Income taxes? Yes.
Now, when you sell, transfer or gift your carried interest to a person related to you, you may recognize a short-term capital gain.
How much? Well, it’s complicated. That’s tax simplification.
Who is this person related to you? Well, that’s changed too. Now it includes not only your relatives but your colleagues, vendors and current or former employees.
Planning Points: Make sure that you talk to your tax advisor before making the transfer. Try to do the transfer on January 1 or December 31 when the fund can value the fund assets.
ENTITIES SUBJECT TO THESE RULES
These rules apply to individuals, trusts and estates, but not corporations.
Planning Point: It may be possible to hold the carried interest in an S Corporation and avoid these rules.
TYPES OF BUSINESS SUBJECT TO THESE RULES
The ACT only applies to partnership interest (which may include limited liability companies) that hold entities that raise or return capital from investors (VC’s, PE’s and hedge fund managers), investing in, disposing of, or developing securities, commodities, cash options or derivatives, (investment fund managers) and real estate held for rental or investment.
Entities not subject to the ACT
Farmers that hold land in which they actively farm are not subject to these new rules.
Additionally, these rules generally should not apply to “profit interest,” granted to service providers who are employed by a related but separate entity (e.g. a management company).
The rules also do not apply to gains attributable to any asset not held for portfolio investment on behalf of third-party investors. We will have to wait for more guidance for this definition.
There are still many unanswered questions regarding these new rules, with hopefully more guidance coming from the IRS and Congress. Practically speaking, if you’re involved in investments, and hold the assets for more than three years, then these new rules will not have much impact. Furthermore, California has not adopted these rules.
However, there are still numerous traps for the unwary. At GROCO, we assist high net worth clients and their families with wealth creation, family transfers, taxes and charitable giving. Please give me a call at 510-797-8661 if you need assistance or have questions on these new rules or would like to know how to make, keep and/or transfer your wealth.
We hope you found this article “Maximizing the Value of your Carried Interest” helpful. If you have questions or need expert tax or family office advice that’s refreshingly objective (we never sell investments), please contact us or visit our Family office page or our website at www.GROCO.com. Unfortunately, we no longer give advice to other tax professionals gratis.
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Alan Olsen, is the Host of the American Dreams Show and the Managing Partner of GROCO.com. GROCO is a premier family office and tax advisory firm with clients all over the world.
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