The “carried interest” receives further scrutiny (and clarity). What does this mean for private client family enterprises and their family offices?
There are a series of national and international developments impacting the holding, structuring, and management of family capital. Because the US remains one of the world’s important investment destinations, US tax law developments are important for many investors. One important area in the investment management space is the US tax treatment of carried interest (also referred to as a profits interest or incentive allocation), which typically involves participation by the manager in the profits of a portfolio of investments owned directly or indirectly by an entity that is treated as a partnership for tax purposes. A carried interest arrangement often allows for an efficient transfer of capital, retaining tax character, between and among actors within a family enterprise. Such an arrangement supports these actors’ expectations that equity-based ownership will result in tax characterization as capital in nature, rather than ordinary, to the extent that the underlying portfolio generates capital gains.
Carried interest arrangements are widely used to reward key investment professionals for positive growth in the value of investments. A carried interest, which is essentially a method of sharing profits with those who manage the investments, is most commonly found as a part of the economic structure of real estate, private equity, venture capital and hedge funds, but is also gaining in popularity for the management of privately held capital, such as by family offices. Family enterprises and their family offices structure investment capital in consolidation vehicles and often want superior talent to help manage those investments; to attract the sought-after talent, families and their family offices are frequently employing incentive allocations for managers. This is often an attractive and appropriate way of aligning interests to preserve and grow a family’s financial capital, regardless of whether the family office is already existing and operational through generations or is a newly created aspect of a family enterprise, such as in the case of newer tech entrepreneurs who are increasingly creating family offices to manage their personal and nuclear family investments and activities.
Since family offices are also tasked with representing broad family interests and should, ideally, remain sensitive to variations in attitudes to wealth, the incentive allocation is something that might apply to outside managers but can also apply to family members themselves, as they seek to be good stewards of family capital for future and rising generations.
US tax rules enacted as part of the Tax Cuts and Jobs Act of 2017 place limits on the tax benefits associated with carried interests. Specifically, the new rules generally impose a three-year holding period requirement, rather than the standard one-year holding period requirement, in order to receive long-term capital gain (LTCG) treatment (and associated preferential tax rates for non-corporate taxpayers) with respect to certain capital gains realized in connection with so-called “applicable partnership interests” (APIs).
Subject to certain exceptions, APIs are partnership interests transferred to or held in connection with the performance of certain services by the taxpayer on a regular, continuous and substantial basis involving the raising or returning capital and either (i) investing in (or disposing of) specified assets, or (ii) developing specified assets. For these purposes, specified assets include stock, securities, options and derivatives, as well as real estate. Additionally, a partnership interest, itself, is considered to be a specified asset to the extent its assets consist of specified assets, or if the partnership is considered to be publicly traded or widely held. Based on these parameters, many carried interest arrangements will constitute APIs and, absent an exception, will be subject to the three-year holding period mentioned above. Affected capital gains are treated as short-term capital gains (STCG), which are generally taxable to non-corporate taxpayers at ordinary rates, currently up to 37% (whether gains are LTCG or STCG, a 3.8% net investment income tax may also apply).
Proposed regulations published on July 31, 2020 (the Proposed Regulations) offered some clarity around the operation of those limits and provided some flexibility in applying the rules. However, the Proposed Regulations also fell short of taxpayers’ expectations in some places. On January 7, 2021, final regulations (the Final Regulations) were promulgated, which cemented some rules in the Proposed Regulations and revised others, generally in taxpayers’ favor. Subject to certain exceptions, the Final Regulations will apply to tax years beginning on or after January 19, 2021; however, taxpayers are permitted to apply the final regulations to tax years beginning after December 31, 2017, provided that they apply the final regulations in their entirety to that year and all subsequent years.
Below is a summary of some of the key issues associated with the 2017 legislation and the regulations promulgated thereunder, and observations on how they may impact some family enterprises and family offices.
Family office exception
The statute provides regulatory authority to establish an exception to the special three-year holding period rule for income or gain attributable to any asset that is not held for investment on behalf of any “third-party investor” (generally speaking, an investor that isn’t related to the service provider holding the API and whose interest does not, itself, constitute an API). This exception is commonly referred to as the “family office” exception because family office portfolio investments are often made on behalf of the service providers and persons related to the service providers. The preamble to the Proposed Regulations stated, "Comments have suggested that the exception is intended to apply to family offices, that is, portfolio investments made on behalf of the service providers and persons related to the services providers."
The Treasury Department and the IRS generally agree with these comments and believe that the section 1061(b) exception effectively is implemented in the proposed regulations with the exception to section 1061 for Passthrough Interest Direct Investment Allocations. The Final Regulations, it should be noted, removed the passthrough interest direct investment allocation framework, and the preamble to the Final Regulations notes that Treasury is continuing to study the family office exception, generally.
Although Treasury and the IRS do not define “family office” in this context, a reasonable definition can be found in the regulations promulgated under the Investment Advisers Act of 1940, which define “family office” to mean “a company (including its directors, partners, members, managers, trustees, and employees acting within the scope of their position or employment) that: (1) has no clients other than family clients; provided that if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person shall be deemed to be a family client for purposes of this section for one year following the completion of the transfer of legal title to the assets resulting from the involuntary event; (2) is wholly owned by family clients and is exclusively controlled (directly or indirectly) by one or more family members and/or family entities; and (3) does not hold itself out to the public as an investment adviser. (See, 17 C.F.R. § 275.202(a)(11)(G)-1(b)).
The statutory exception in section 1061(b) is not considered to be intended to encompass APIs issued to third-party professionals who manage family office investment portfolios. Preferential treatment for such investment managers would result in different tax treatment for compensatory equity received by professionals engaged by family offices and those received by professionals engaged by funds, which would be an inequitable result lacking a policy rationale.
Importantly, this exception doesn’t become effective until it is activated through regulations or other guidance. Both the Proposed Regulations and the Final Regulations reserved on this exception. As a result, the statutory exception remains unavailable. As noted above, the preamble to the Proposed Regulations espoused the belief that the family office exception was effectively implemented as part of the Proposed Regulations’ expansion of the capital interest exception (discussed below). However, it was not entirely clear under the Proposed Regulations whether the capital interest exception would, in fact, exempt API holders in family office structures from the three-year holding period rule to the same extent that the family office exception would, if it were operationalized by regulations.
Clarifications of the scope of the capital interest exception in the Final Regulations do not satisfactorily resolve this issue either. Specifically, the capital interest exception does not appear to encompass an API granted to a family member engaged to manage a family office's investment portfolio. This coverage gap is material; an investment diversification target can quickly result in a family office portfolio requiring management on a significant part-time, or full-time, basis. Family offices should be able to fairly compensate family members, whose knowledge of family office portfolio goals is substantial and whose interests are in particularly high alignment with the other investors', for this employment within a regime that recognizes their role as direct or indirect co-participants in the overall investment program.
It should also be noted that an effective regulatory regime for section 1061(b) would need to include a workable framework for determining the “relatedness” of service providers in the family office context, properly taking into account different related lines of lineage and marriage, including sequential marriages.
Accordingly, it is advisable for family offices and their advisors to closely monitor developments relating to the family office exception, because it may have significant implications for family structures where some or all of the API holders are family members.
Exception for capital interests
The three-year holding period rule does not apply to a partnership interest (or portion thereof) with respect to which allocations of capital gain or loss are made based on the relative capital accounts of the partners. To qualify, the holder’s allocations with respect to its contributed capital must broadly match the allocations of other non-service partners who represent a “significant” portion of the partnership’s aggregate capital account balance (at least 5%). The Proposed Regulations indicated that an allocation would not fail to qualify solely because it is subordinated to allocations made to unrelated non-service partners or it is not reduced by the cost of services provided to the partnership by the API holder or a related person (e.g., management fees). The Final Regulations eliminated the requirement that allocations to API holders must be based on relative capital account balances, and relaxed other aspects of the capital interest exception; this has made the exception more broadly available to funds that do not make allocations in accordance with capital account balances.
Capital interests funded by a loan from another partner in the partnership (or related person to that partner, other than the partnership, itself) may qualify for the Capital Interest Exception, provided the borrower remains personally liable for the loan. The debt permission is important because, many times, individual managers do not have ready access to the magnitude of capital necessary to invest at the desired level, and in a closely-held business, it is not uncommon for these investments to be made on credit. (In addition, many funds offer loans to employees to purchase equity as a matter of course.) This rule prevents an IRS argument that because an investment was funded with debt it should not be respected as an investment until the principal is repaid. Capital interest allocations must be clearly identified both under the partnership agreement and on the partnership’s books and records as separate and apart from allocations made to an API Holder with respect to its API, raising the possibility that some partnership agreements may need to be amended in order to support qualification for this exception.
Overall, the capital interest exception is beneficial to family members who are invested in the partnership and who also manage the partnership investments on a part- or full-time basis. But, of course, it does not address the gap noted above in the discussion of the family office exception.
Carried interests issued to certain corporations
Under the statute, APIs held directly or indirectly by corporations are not subject to the three-year holding period regime. Consistent with prior guidance, the Proposed Regulations provided, and the Final Regulations reiterate, that an S corporation is not considered a corporation for purposes of this exception, which is not surprising given the flow-through nature of S corporations.
Corporations are less commonly used for management vehicles in the purely domestic private placement industry, but are more common in the private family setting. Corporations might be organized to serve as a family office or private trust company and might participate in underlying family investment partnerships, earning a carried interest for services performed. In those cases, the business activity and incentives provided make the C Corporation option compelling. Additionally, there may be less relative sensitivity to the two levels of tax resulting between a C corporation and dividends distributed to its shareholder(s). For families with Corporation family offices or private trust companies, carried interest planning is highly relevant and might have great value, but the limitations imposed by these new regulations, relating to S corporations should be taken into account as applicable.
The regulations also bar from the “corporate holder” exception for APIs owned by any “passive foreign investment company” or “PFIC” for which a “QEF election” has been made (a PFIC with a QEF election in place functionally is a C corporation that is taxed in a manner similar to a flow-through vehicle).
Certain investments in real estate and financial instruments
The Proposed Regulations took the position, and the Final Regulations confirmed, that certain types of income that are treated as LTCGs or qualify for preferential LTCG rates, regardless of holding period, are unaffected by the three-year holding period rule. Importantly, this includes the gain on certain depreciable real and personal property used in a trade or business that is treated as long-term capital gain under Section 1231 of the Code. This means that capital gains generated by family office real estate investments, which are often held through tiered partnership structures, may continue to qualify for LTCG treatment regardless of holding period.
Other types of income not subject to recharacterization under the three-year rule include qualified dividend income (i.e., dividends paid by domestic C corporations and certain foreign corporations that satisfy applicable treaty qualification requirements) and certain regulated futures contracts, foreign currency contracts, and non-equity options that are annually marked-to-market, with gains treated as partly LTCG and partly STCG. Capital gain dividends paid by REITs and RICs may also qualify, depending on the source of the dividend, and subject to the satisfaction of certain reporting requirements by the distributing REIT or RIC.
Considerations where the three-year holding period rules apply
Holding period determinations
For purposes of making holding period determinations under the three-year holding period rule, the relevant holding period generally is the holding period of the asset that is sold or exchanged. For instance, if a fund sells stock of a portfolio company, the relevant holding period is the fund’s holding period in the portfolio company stock (as opposed to the holding period of the carry vehicle in its carried interest in the fund, or an individual carry partner’s holding period in the carry vehicle). By contrast, if a partner recognizes gain from the sale or exchange of an API (whether actual or deemed), subject to the look-through rule discussed below, the relevant holding period is generally the partner’s holding period in the API.
The Proposed Regulations included a limited look-through rule (Lookthrough Rule) that, where applicable, would have had the effect of overriding the general holding period rules discussed above where 80% or more of the fair market value of the relevant partnership’s assets were assets that would produce STCG or STCL if disposed of by the partnership. Under the Final Regulations, the Lookthrough Rule was significantly scaled back and replaced with an anti-abuse rule that applies where, at the time of a disposition of an API held for more than three years, (1) the API would have a holding period of three years or less if the holding period of the API were determined by excluding any period before which third-party investors have capital commitments to the partnership, or (2) a transaction or series of related transactions has taken place with a principal purpose of avoiding potential gain recharacterization under section 1061(a).
Family planning and related party transfers
The Final Regulations also removed a provision in the Proposed Regulations that treated the transfer of an API to a related person in an otherwise non-taxable transaction as an acceleration event under section 1061(d). The statute provides that transfers of APIs to related parties are treated as taxable transfers to which the three-year holding period may apply. The Proposed Regulations interpreted this to include nontaxable transfers (such as gifts), posing a challenge to common intra-family transfers. Specifically, the Proposed Regulations indicated that, once a partnership interest qualifies as an API, it generally remains an API regardless of subsequent transfers, gifts or other dispositions, unless and until an exception becomes applicable. In the Final Regulations, however, Treasury determined that it is more appropriate to apply the statutory provision only to transfers in which gain is otherwise recognized.
Management “waivers” of a carried interest rights will be scrutinized
The preamble to the Proposed Regulations indicated that Treasury and the IRS are aware that API holders may seek to circumvent the three-year holding period rules by waiving rights to gains on the disposition of property held for three years or less and substituting rights to receive proceeds from gains generated from the disposition of capital assets held for more than three years. Treasury warned that taxpayers should be aware that such waivers may be challenged under various principles of Subchapter K and judicial doctrines.
Reporting requirements, as always, need to be addressed
The regulations require API holders to report specific information to evidence their compliance with the three-year holding period rules, and require partnerships that have issued APIs to provide information to their partners through Schedules K-1 sufficient to facilitate those reporting requirements and permit API holders to determine their LTCGs and STCGs under the three-year holding period rules.
Given the substantially reduced rates available for LTCGs under current law, provisions such as the three-year holding period rules that act as the gatekeepers to those preferential rates cannot be ignored. As noted above, depending on their specific facts, family offices may be able to take steps to minimize the impact of the three-year holding period rules on the managers they choose to incentivize with carried interests. Critical to this analysis will be if and when Treasury ever chooses to operationalize the family office exception and, if so, how the government chooses to do so. Thus, as noted above, this is an area that deserves careful attention and monitoring by family offices.