In a previous memorandum we analyzed certain proposals in the House and Senate tax reform bills (the “Bills”) that are of particular salience to our Investment Management, Trusts & Estates and Family Office clients. Each Bill contains nearly identical provisions that, if enacted, materially change the tax treatment of investment fund managers/general partners (the “Carried Interest Proposal”). This Client Alert focuses specifically on the Carried Interest Proposal.

I. The Carried Interest Proposal

The Bills provide that, as of January 1, 2018, a taxpayer’s distributive share of partnership gain will be treated as short-term capital gains (which are taxed at higher ordinary income rates) to the extent such gains result from the sale or exchange of an asset held by the partnership for three (3) years or less. This proposal has the effect of causing a substantial amount of incentive allocation income (that had in the past been allocated to the general partner of an investment fund as long-term capital gains) to be treated as short-term capital gains. The highest marginal income tax rate applicable to short-term capital gains is 39.6% (this rate is reduced to 38.6% under the Senate proposal). Long-term capital gains are subject to a maximum tax rate of 20%.

This potential change in law would apply to all partnership interests that were held (directly or indirectly) by taxpayers (and certain affiliates) that are raising or returning capital and either investing in, developing, or disposing of securities, commodities, rental or investment real estate, cash and cash-equivalents, and options or derivatives on behalf of the partnership. Affiliates of taxpayers subject to the Carried Interest Proposal include certain family members, estate planning vehicles and certain service providers of the partnership to whom the taxpayer may transfer a partnership interest.

This three-year holding period requirement does not apply to the extent of investment professionals’ capital investments in their own funds. The Carried Interest Proposal also provides that the Secretary of the Treasury shall specify the extent to which the three-year holding period requirement does not apply to gains attributable to assets not held for portfolio investment on behalf of third party investors.

It should be noted that the Senate tax reform bill that would also require private investment funds to treat their securities as sold on a first in-first out (“FIFO”) basis rather than utilizing a different tax lot identification method (such as LIFO, highest cost or specific identification).

II. S&K Insights

This potential change will impact investment funds differently depending upon their investment strategy.

Managers of real estate funds, private equity funds and value investing hedge funds may not be materially impacted by this potential change, particularly if they generally hold their assets for longer than three years. Most gains derived by such funds should still qualify for long-term capital gains treatment.

The managers who will be most affected by the proposed change are those managers who have typical securities holding periods of greater than one year but less than three years. Under this proposal, those managers could see a substantial amount of long-term capital gain (and possibly qualified dividend income) converted to short-term capital gain.

In addition, if the FIFO proposal is enacted, managers will lose the ability to choose the tax lot their fund is selling. As a result, a fund will be treated as selling the tax lot with the longest holding period. This could limit the ability to sell high cost tax lots (where multiple lots of a single security are held) and generate realized losses to offset realized gains at the end of a year.

Managers who are interested in how the bill may affect their specific situations and their year-end tax planning should call us to understand fully the various factors they may wish to consider.

For additional information, please contact one of the attorneys listed below.