Action points for investment, private equity and real estate fund managers

Investment, private equity and real estate fund managers should familiarize themselves with the complex final carried interest preferential tax treatment rules under Section 1061 of the Internal Revenue Code (Code), which generally apply to tax years beginning on or after January 1, 2022.

Preferential treatment of carried interests

Often referred to as a “promote” in the real estate mutual fund industry, a “carried interest” is a profit share in an investment-oriented partnership or limited liability company that is taxed as a partnership for federal income tax purposes (each, an “Investment Pass-Through Entity”) held by the manager who provides investment management services to that company for a fee (fund manager) (eg, the general partner of the partnership or the managing partner of the limited liability company).

For the fund manager, the primary benefit of a carried interest/promote is the preferred state income tax treatment of distributions from the investment pass-through entity: if the assets are held in the investment pass-through entity for the required holding period (currently greater than three years; prior 2018 more than a year), gains from the sale of such assets are passed on to the fund manager – and by extension, directly or indirectly through the fund to employees of the fund manager who holds equity interests in the investment pass-through entity – as capital gains and not as profits subject to ordinary income taxation. Accordingly, the Fund Manager (and its employees who have direct or indirect equity interests in the investment conduit company) receive in consideration for providing investment management services to the investment conduit company investment Income taxed at a capital gains rate of up to 23.8% instead compensation Income taxed at the ordinary income tax rate of up to 37%.

Tax Reduction and Employment Act

In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), which was signed into law by President Donald Trump. The TCJA attempted to limit the assumed preferential treatment of carried interest/promotion by requiring the assets held by the investment pass-through entity to be held for more than three years (instead of more than one year) in order for the capital gains to be triggered by selling such assets (and passing them on to the general partner or managing director, if applicable) in order to qualify for the long-term capital gains treatment.

Section 1061 of the Code, the Carried Interest/Promote statute added by the TCJA, only applies to an “Applicable Partnership Involvement” (API). The law generally defines an API as an interest in a partnership (including a limited liability company taxed as a partnership for federal income tax purposes) that qualifies as an “applicable trade or business” and is transferred (or held) directly or indirectly by) a taxpayer in connection with the provision of essential services by the taxpayer.

On the other hand, an “applicable trade or business” generally means an entity that regularly, continuously and in significant amounts raises or returns capital and either:

  1. investing in (or disposing of) certain assets (or identifying certain assets for such investment or disposal); or

  2. development of such assets.

Investment pass-through entities are generally considered applicable trades or businesses. Unless an exception applies, the carried interests/promotes held by the fund manager (and its employees involved therein) generally qualify as APIs subject to the greater than three year holding rule (API holding rule).


The law provides for three exceptions. First, in certain circumstances, the API Holding Rule does not apply to income or gains attributable to assets not held for portfolio investment on behalf of third-party investors.

Second, an API does not include an interest in a partnership (or a limited liability company that is taxed as a partnership for federal income tax purposes) that is directly or indirectly held by a corporation (hence the API holding rule does not apply to it).

Third, an API does not include certain equity investments.

Final Provisions

In January 2021, the Treasury Department issued final regulations under Section 1061 of the Code. These final rules (which followed the proposed rules issued in July 2020) clarified the requirements for the application of the capital interest exemption that must be borne by loans made by partners or members of the investment pass-through society to employees who wish to acquire equity interests therein personal liability for the employee (while loans were banned by the Investment Pass-Through Entity itself), the “look through” scaled back in relation to the sale of APIs, under which APIs held for more than three years could be subject to short-term capital gains treatment (im Normal income tax rates would generally apply) and clarified the scope of the Act in relation to transfers of agents to connected persons.

action items

The final provisions are complex. From the perspective of a fund manager attempting to incentivize key employees/shareholders in relation to carried interests/promotes and equity participations in investment pass-through entities, the following actions should be considered in 2022:

  1. Determine if the investment pass-through units are applicable trades or corporations. One cannot have an API unless the interest is in a related trade or business. An important determination is whether the investment pass-through entities are engaged on a “regular, continuous and material basis” in activities that would otherwise result in applicable trading or business status.

  1. Inventory of sales history of assets held by investment pass-through entities. If the assets held by the investment pass-through entities are typically held for more than three years (often the case in real estate development and investment space), Section 1061 of the Code should not pose as much of a problem.

  1. Review of articles of association and company agreements in connection with the granting of capital shares. The Final Rule generally requires that equity shares receive attributions that are determined and calculated in a similar manner as attributions in respect of equity shares held by similarly situated independent non-service partners and members who have collectively made significant capital contributions.

  1. Structure loans to acquire equity investments carefully. Few key employees will be satisfied with a loan from a general partner or member. (The requirement also extends to loan guarantees.) In addition, loans from the investment pass-through entities themselves are prohibited. In applying these Rules, certain concepts of “connected person” apply.

  1. Examine the holding periods of drug sales held longer than three years. The final provisions categorize the holding period as three years or less if: (1) the holding period does not include time before the point at which an independent partner or member who does not provide essential services to the investment conduit company becomes legally required; contribute cash or property to the investment pass-through entity; or (2) the sale of the API is part of a transaction or series of transactions whose primary purpose is to avoid the application of Section 1061 of the Code.

The carried interest/promote tax rules require careful planning and almost always expert legal analysis applying Section 1061 of the Code and the Final Regulations to the facts at hand. This analysis is perhaps even more important when dealing with tiered partnerships and limited liability companies.

Jackson Lewis PC © 2022National Law Review, Volume XII, Number 168

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