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Carried Interest Taxed as Ordinary Income

Which Tax Changes in the Federal Government’s 2023 Budget Could Impact Private Equity and Alternative Asset Management Funds?

President Biden’s FY 2023 Budget blueprint, which is commonly known as the green book, provides a detailed analysis of the tax policy proposals present in the federal budget. Although the proposals need to be passed in Congress, it’s important to look at proposed changes to the taxation of capital gains and carried interest, which could have an impact on private equity and alternative asset management funds.

Will long-term capital gains and dividend income be taxed as ordinary income?

Currently, long-term capital gains and qualified dividends are taxed at a preferred rate of either 0%, 15% or 20%. The FY 2023 budget proposes to tax long-term capital gains and qualified dividends at an ordinary income tax rate when a taxpayer’s taxable income is over the $1 million threshold. This proposal was also presented in last year’s green book, but it did not receive a favorable reaction from the Congress.

Will carried interest be taxed as ordinary income?
Carried interest is a profit-sharing model typically used by private equity, venture capital and hedge funds. Under section 1061 of the IRC, taxpayers can benefit from favorable long-term capital gains tax rate associated with carried interest if they satisfy a three-year holding period.

Under the Biden Administration’s proposal, a partner’s share of income on an “investment services partnership interest” (ISPI) would be taxed as ordinary income if the partner’s taxable income (from all sources) exceeds $400,000, regardless of the character of income at the partnership level. An ISPI is defined as a profits interest in an investment partnership that is held by a person who provides services to the partnership.

Under the proposal, a partnership would be considered an “investment partnership” if substantially all of its assets are investment type assets, but only if over half of the partnership’s contributed capital is from partners to whom the interests constitute property not held in connection with a trade or business.

IRC section 1061 would still apply to profits-interest holders with taxable income less than $400,000, which means they can still benefit from long term capital gains treatment of carried interest if they satisfy the three-year holding period.

The Biden Administration has been calling for a capital gains tax hike for households with income over $1 million and this proposal to convert what is otherwise long-term capital gain (subject to IRC Section 1061) into ordinary income falls into the same plan.

Article by Muhammad Junaid, Senior Tax Manager

Matthew John McNally
Matthew is an enrolled agent with two decades of tax planning, compliance, and advisory experience, much of it at Big Four accounting firms, where he guided clients with wide-reaching financial concerns.