Taxation of Carried Interest: How to Plan for Changes

It’s been a busy year in Washington, and it doesn’t look like things will be slowing down anytime soon. One issue that has been making waves is potential changes to the taxation of carried interest. Today, the rules for taxation of investment partner compensation — and, in particular, compensation in the form of a share of investment profits, or carried interest —create a tax savings opportunity. By taking a portion of compensation as carry, investors can convert their earnings from ordinary income into long-term capital gains. And that difference is massive. For a Californian or New Yorker, it could lower the effective tax rate on carry from 50% to 35%!

With that said, this may all change soon: Congress has considered reforms to carried interest taxation — “closing the carried interest loophole” — many times over the years, and specific reforms even made it into an early draft of the Inflation Reduction Act that just became law. So what does all this mean for investors, and particularly for the General Partners (GPs) who derive most of their income from carried interest? In this blog post, we will discuss taxation of carried interest and how to plan for potential changes to protect your tax savings.

What Is Carried Interest in Private Equity and Venture Capital?

Carried interest, or BDIT, is a term used for the profits generated from investments and is primarily used as compensation for investment professionals such as Private Equity and Venture Capital. The carried interest works because the holder receives a share of the profits from the partnership’s investments. Carried interest profits typically apply to institutional professionals across most sectors, such as real estate, private equity, debt, and venture capital.

The origins of carried interest can be traced back to the Middle Ages, when merchants would form partnerships to finance trading expeditions. The partners who provided the capital for the expedition would earn a carried interest rate on their investment, which was seen as compensation for the risk they were taking.

Today, carried interest is still used to compensate investors for the risks they are taking, but it has also become an important tool for tax planning. By earning carried interest, investors can reduce their taxable income and save money on taxes.

Why Do Professional Investors Receive Carry?

Carried interest is a way for limited partners (LP’s), the primary investors in investment funds, to align their incentives with fund investors, GP’s or General Partners, and financially incentivize the GP’s to choose better investments and generate superior risk adjusted returns. The better an investment fund performs, the more profits General Partners generate for themselves and Limited Partners, and the happier everyone will be.

Carried interest can be structured in a number of different ways. The two most common carry structures include:

1. A “hurdle rate” is typically the most common. This is a threshold that must be met before the carried interest holder begins to receive profits. The hurdle rate is usually set at a minimum annual return that the partnership must achieve, and typically the General Partners will receive 20% of the profits above that rate.
2. Early distributions for estimated profits above the hurdle rate before the fund has fully realized its investments. This allows fund investors to receive carry interest distributions earlier on in a fund cycle instead of waiting until the fund winds down. But it’s not without risks, these funds will usually have a “clawback” provision that allows the investment fund to reclaim some or all of the GP’s previously distributed carry if the partnership fails to meet certain performance goals.

But let’s analyze a specific example on carried interest of how this might play out!

Let’s say a fund was doing well in its early years, and looked to be delivering a 10% return compared to its 8% hurdle. The fund might distribute carry out to its GPs early before the fund closed. However, by the end of the fund it had only returned 5%, investors (limited partners) may be entitled under the terms of their investment agreement to “claw back” a portion of the carry paid to the general partners to cover the shortfall when the fund sunsets. This clawback provision is a key part of the argument as to why carried interest isn’t taxed as ordinary income.

Taxation of Carried Interest: Why Is It Taxed as Capital Gains?

Carried interest is currently treated as capital gains, which means that it is taxed at a lower rate than ordinary income. This tax treatment has led to heavy criticism, as some people argue that it is unfair for investors to enjoy such a tax advantage and pay a lower tax rate than the ordinary income tax rate most people pay. However, defenders of carried interest argue that this tax treatment is appropriate, to encourage better investment and increased economic growth.

Tax Savings Opportunities For Carried Interest

There are a number of ways that investors can save money on their carried interest taxes simply by taking advantage of carried interest’s structure. All of these typically center around transferring the carried interest out of your name when a new fund is formed, in order to take advantage of carry’s low cost basis before any investments have been made. The solution typically depends on where you live and if you are focused on tax or estate planning. (You can read more about each strategy in their respective blog posts which we’ll share at a later date. 

• Estate Planning (for individuals currently focused on maximizing the assets they pass on to future generations): To avoid estate taxes and generation skipping taxes wealthy investors often gift their carried interest to irrevocable dynasty trusts that their future generations can benefit from the preferential tax treatment. At the origination of the fund, the carried interest has its lowest value, so typically this planning will take place soon after the fund is formed in order to achieve maximum benefit by minimizing estate taxes.

To take this to a more advanced level, many of the most well known venture investors will not only gift or sell their carry to a dynasty trust but make their GP commit, their required fund financial commitment, from their dynasty trust to further move assets out of their estate and reduce their future potential estate taxes.

• Tax Planning (for individuals currently focused on the assets they will be able to use): To avoid state taxes, which in New York and California can run north of 13%, investors often use what is called a parent seeded trust to shift ownership of their carried interest to a trust based in a no tax state, such as Nevada or South Dakota, so they can avoid state taxes on their carry proceeds.

Have the investment fund distribute shares of the underlying investments instead of the proceeds of the sale of those assets to General Partners. It gives you more flexibility to take advantage of more tax advantaged planning like QSBS, QSBS Stacking and Charitable Remainder Trusts among other options.

Will carried interest get taxed as ordinary income?

The so-called carried interest loophole became a political hot topic as early as 2007, and legislation that would increase the taxes on carried interest has been on the brink of passage multiple times since then, including this year. The case for increasing taxes on carried interest is primarily about optics: it’s good politics to say that you’ve increased taxes on wealthy fund managers and passed the revenue on to another, more needy constituency.

So why hasn’t Congress eliminated the carried interest loophole? Two reasons:

1. The tax savings at stake are fairly small — about $15 billion in additional revenue, or about 0.3% of the $5 trillion federal budget.
2. Professional investors are a small but politically powerful interest group, which can impact law makers’ decisions on this topic.

At the same time, the political winds are changing. Efforts at progressive redistribution have been successful since the Democrats took power — witness the recent federal student loan forgiveness — and carried interest reform has gotten more positive press in the latest debates in Congress. With those developments in mind, it’s smart to plan for a world in which the loophole closes.

Carried Interest Risks

In recent years, there has been a renewed focus on carried interest and the preferable tax treatment that comes with it. Opponents of carried interest argue that it amounts to a tax break for the wealthy. Because investment managers are able to classify their income as carried interest, they can avoid paying taxes on it at the same rate as regular income. Defenders of carried interest argue that it is not a loophole, but rather a legitimate way to reward those who take on substantial risk in the investment world.

The debate over carried interest has heated up in recent years, as lawmakers have sought to close the “loophole”, effectively increasing the tax rate. The debate over carried interest is likely to continue in the years ahead, as lawmakers seek ways to reduce the federal deficit and pay for other priorities. We’ve even seen prominent firms like Sequoia Capital change their fund structure and distribution plan to mitigate the risk of higher taxes from potential legislative changes.

What is the Carried Interest Tax Loophole?

The so-called carried interest loophole became a political hot topic as early as 2007, and legislation that would increase the taxes on carried interest has been on the brink of passage multiple times since then, including this year. The case for increasing taxes on carried interest is primarily about optics: it’s good politics to say that you’ve increased taxes on wealthy fund managers and passed the revenue on to another, more needy constituency.

So why hasn’t Congress eliminated the carried interest loophole? Two reasons:

1. The tax savings at stake are fairly small — about $15 billion in additional revenue, or about 0.3% of the $5 trillion federal budget.
2. Professional investors are a small but politically powerful interest group, which can impact law makers’ decisions on this topic.

At the same time, the political winds are changing. Efforts at progressive redistribution have been successful since the Democrats took power — witness the recent federal student loan forgiveness — and carried interest reform has gotten more positive press in the latest debates in Congress. With those developments in mind, it’s smart to plan for a world in which the loophole closes.

What can firms do to reduce taxes on carry if legislation passes?

Proactive firms have pursued a couple of solutions that are worth considering.

• Preemptively distributing shares from existing investments to SPVs

The most effective way to get ahead of potential reforms is to distribute carry before any rule changes come into effect, so that the distributions will be taxed under the current rules. It’s not typically possible to distribute proceeds before they’re liquid, but some firms have come up with a clever solution. By distributing fund investments to a new SPV now, the distributions may be taxed as long-term gains under the current rules, even if the carried interest loop hole changes in the future.

To be sure, distributing carry proceeds to an SPV does create a taxable event today, whereas waiting for later distributions allows you to defer the gains. The tax rate could be lower, but this is a trade-off that may or may not make sense depending on the size of the expected gain and your liquidity timeline. The greater the asset appreciation that is expected to happen after carried interest reforms, the more valuable this option may be.

This isn’t an option that’s necessary to implement today; a firm can choose to take this step if and when the carried interest loophole closes. But it is worth noting that firms like Sequoia are starting to make precisely these plans.

• Early LP and GP distributions

Preemptive distribution of shares requires serious foresight; it’s not worth doing unless the carried interest loophole closes, and once reform legislation is approved, it’ll be too late.

There is, however, another strategy for reducing the tax on carry even after any reform is enacted: Early distribution of investment proceeds. Typically, GPs wait to distribute the proceeds from an investment until there is a liquidity event, like an acquisition or IPO. If the carried interest loophole closes, though, we may see LPs and GPs begin taking distributions earlier. Distributing shares earlier enables all of the post-distribution appreciation to be tax as capital gains, while simultaneously limiting the ordinary income tax exposure to the initial distribution value. It will incentivize firms to distribute shares when the shares have a lower value (and therefore a lower cost basis for the purpose of capital gains taxation).

The challenge with distributing shares early is estimating the exit value of these investments and correctly allocating the profits to LPs and GPs. While clawback provisions can help, they are unlikely to work for investment firms without long relationships with their LPs.

Next Steps

It is hard to say whether the carried interest loophole is here to say, but in an era of rising taxes, it’s smart for firms and individuals to start evaluating their options. We’ve offered a few ideas for the firms themselves. In next week’s article, we’ll explore some strategies available to individual fund managers to reduce the taxes on their carry, whether the loophole disappears or not.

 Evaluate your potential returns with our CRUT Calculator or get started setting up a meeting with our team of experts!

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