Bill Would End Carried Interest Deferral

On April 16, leading Democrats on the Senate Finance Committee, including ranking member Ron Wyden, introduced the Ending the Carried Interest Loophole Act, which would replace the current carried interest regime with an annual ordinary income inclusion for holders of applicable partnership interests, paired with an equal long-term capital loss in the same year. If enacted, the bill would shift the tax framework from one tied largely to partnership realizations and exit timing to one that taxes a manager’s service return each year based on the use of investor capital. The negative impact on affected taxpayers could be substantial, with the Joint Committee on Taxation estimating that the bill would raise $63.1 billion in revenue over 10 years.

Crowe observation

While Democrats currently are not in control of either chamber of Congress or the White House, the bill provides a preview of a potential revenue offset the Democrats might use to fund other priorities if they gain control in Washington.

Background

Under current law, carried interest generally is a partnership’s profit interest received in connection with services. For decades, the tax debate has centered on whether a partner who manages the partnership should benefit from capital gain treatment and delayed recognition tied to partnership-level realizations or be treated as receiving ordinary income from the provision of services. Congress addressed carried interest in 2017 by enacting Section 1061, which generally requires a three-year holding period, rather than a one-year period, for a partnership manager to be eligible for certain net long-term capital gain associated with an applicable partnership interest. But Section 1061 does not treat carried interest as ordinary income compensation; it only subjects certain gains to ordinary rates if the holding-period requirement is not met.

The recent bill would repeal Section 1061 and replace it with a new Section 1299 that would treat the carried interest as an annual deemed compensation amount for applicable partnership interests. As currently drafted, the bill would be effective for tax years beginning after the date of enactment.

Following are key provisions included in the bill:

• Annual ordinary income inclusion replaces the current Section 1061 framework. Section 1299 would require a taxpayer holding one or more applicable partnership interests to include in ordinary income the aggregate deemed compensation amounts for those interests held during the tax year. At the same time, the taxpayer would be treated as realizing an equal long-term capital loss with respect to those applicable partnership interests. The ordinary income recognized would be taxed at ordinary rates and subject to self-employment taxes.
• The computation of the deemed compensation amount approximates a return on investor capital allocated to the manager. The deemed compensation amount is determined by multiplying a specified rate by the excess of two amounts: the carried interest holder’s applicable percentage of the weighted-average invested capital of all partners, reduced by the weighted-average invested capital attributable to that interest. The bill analogizes a carried interest with an interest-free loan from investors to the manager, with the annual inclusion of the deemed compensation amount approximating the forgone interest on the capital being used for the manager’s account. The loan analogy explains why the deemed income is taxed currently, rather than allowing for a deferral until a fund sale or other realization event before taxing the service component.
• Applicable partnership interest is broadly defined. The term “applicable partnership interest” is any interest in a partnership that is directly or indirectly transferred to (or held by) the taxpayer in connection with the performance of services by the taxpayer, or any other person, in any applicable trade or business, or is held by a taxpayer who received an applicable loan. If an applicable partnership interest is sold or otherwise disposed of during the 10-year applicable period, the bill accelerates inclusion of deemed compensation.
• The definition of applicable trade or business covers the core alternative-asset sectors. Services subject to these rules are services performed in an applicable trade or business. The term “applicable trade or business” means any activity conducted on a regular, continuous, and substantial basis that involves raising or returning capital and either investing in, identifying, acquiring, disposing of, or developing specified assets. Specified assets include securities, commodities, real estate held for rental or investment, cash and cash equivalents, related derivatives, and look-through partnership interests. These definitions cover the trade or business of hedge fund and private equity managers. Section 1061 excludes investments in corporate entities and certain types of gain, such as Section 1231 gain, from the scope of the provision. Proposed Section 1299 does not include these exceptions and, as a result, is substantially more expansive than existing law.
• Several technical inputs will drive modeling and could become focal points for future guidance. The bill contains highly technical definitions related to specified rates and applicable percentages that require detailed tracking and measurement at both year-end and Section 704(b) capital account revaluation dates. If enacted as drafted, the bill imposes significant computational and administrative burdens that would require a reevaluation of existing partnership economic arrangements.
• Disposition, reporting, and anti-abuse rules are integral.Partnerships must report each partner’s deemed compensation amount to both the partners and the IRS, with similar reporting through partnerships and S corporations. The bill directs the U.S. Department of the Treasury secretary to issue guidance on abuse prevention, tiered structures, partnership-linked instruments, valuation distortions in invested capital, and nonrecognition transfers such as gifts, inheritance, and substituted-basis transactions. The breadth of the anti-abuse provision signals that Congress expects structural planning to mitigate the effects of the provision if the bill advances.

Looking ahead

Fund sponsors, advisers, and managers should be aware of the bill’s sweeping provisions and prepare to advocate for their interests with legislators and other stakeholders. They also should consider modeling and discussing the potential impact of the bill with existing investors and investors in fund structures under consideration.