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Proposal to Tax Carried (Profits) Interests as Ordinary Income

Reforms to the tax treatment of carried (profits) interest has been a topic for many years. The Administration aims to ensure equal treatment of labor and capital income since the character of the income for carried (profits) interests has been under scrutiny.

What are carried (profits) interests?

In a partnership, certain partners generally receive partnership interests in exchange for contributions of cash and/or property while certain partners receive partnership interests in exchange for services. Partnership “interests” typically refers to future profits of the partnership commonly known as “profits interests” or “carried interests.” Carried (profits) interest holders are usually general partners who are fund managers of the investment companies and are compensated for their services in the form of management fees1 or carried (profit) interests. Management fees are usually a percentage of the fund’s assets and carried (profits) interests are a percentage of the fund’s profits.

What are the tax implications?

Under the current law, Section 1061 allows carried (profits) interest holders to be eligible for preferential capital gain rates for the profits and gains received if they satisfy a three-year holding period2. Long-term capital gain tax rates are generally lower compared to marginal tax rate for ordinary income. The top tax rate for long-term capital gains is 20 percent whereas the ordinary income’s rate is 37 percent. Generally, income generated from investments due to an increase in the value of capital assets can benefit from preferential tax rates if the holding period has been satisfied thus critics argue that the carried (profits) interest should be taxed at ordinary rates and be subject to self-employment tax since such income is derived from performance of services which is essentially a service provider under labor income.

Under the Administration’s Fiscal Year 2024 Revenue Proposals, if the partner’s taxable income (from all sources) on “investment services partnership interest” (ISPI) exceeds $400,000, the partner’s share of income is taxed as ordinary income regardless of the character of the income at the partnership level. This proposal would be effective for taxable years beginning after December 31, 2023. For investment partnerships such as private equity funds and hedge funds, there will be a significant impact since preferential tax rates are no longer applicable and the income generated from ISPI can be substantial. This will ultimately drive the partners with carried (profits) interest into a higher tax bracket.

1 Management fees are taxed as ordinary income.
2 The Tax Cuts and Jobs Act of 2017 extended the holding period from one year to three years.
3 An ISPI is carried (profits) interest in an investment partnership that is held by a person who provides services to the partnership.

Article by Aisan Wu, Tax Manager

Aisan Wu
Author: Aisan Wu
Aisan is a certified public accountant who provides federal and state income tax compliance and advisory services for private equity and venture capital funds, and private equity portfolio companies.