Carried Interest Remains Intact, New Code Section 1061 is a Farce

The 2016 Presidential Campaign of Donald J. Trump made closing the so-called “carried interest” loophole one the primary issues of the campaign. He accused the very standard provision of being a loophole for Wall Street and the wealth that were “getting away with murder.”

The Tax Cuts and Jobs Act created new Internal Revenue Code section 1061 intended to treat hedge funds that operate via partnerships differently from other partnerships by putting limits on the ability of an investment manager to partner with a hedge fund and receive a capital interest in exchange for professional services, which is sometimes called “sweat equity,” that would be taxed as long-term capital gain upon disposition.

In startup companies, sweat equity is considered something positive; giving employees ownership in the company as a reward for excellent service. But when it involves Wall Street, it’s viewed unfavorably because the investment managers will typically have an artificially low salary replaced with more equity. Nevertheless, the rationale behind long-term capital gain is to reward those who take risks since risk is a critical part of a capitalist economy. If you exchange guaranteed salary for speculative equity, you are taking a risk for which you should be rewarded with a lower tax rate on any resulting gain. After all, when private equity funds do well, it’s because they turned a company around saving many jobs in the process. And while turning around a company may involve significant layoffs, a company going bankrupt would result in layoffs of the entire workforce. The same argument cannot be made for short-selling hedge funds , however.

Policy aside, the new Code section 1061 increases the required holding period from 1 year to 3 years. However, it’s full of obvious loopholes. For example, in prohibiting the granting of an equity interest, it only applies to the individual and his or her family members; it does not apply to transfers made indirectly into entities. This was intentional. Code section 1061 is political theater; it’s a farce easily circumvented with simple planning. There is simply no way this was not intentional because the indirect ownership attribution rules were intentionally limited to only Code section 318(a)(1) rather than the entirety of the comprehensive Code section 318, which would have included indirect ownership through partnerships, corporations, and trusts.

While the new Code section 1061 is easily avoidable, existing hedge funds and private equity funds will have to restructure slightly to avoid being subject to the new Code provision. If you’re an investment manager with a carried interest in a hedge fund, contact the tax attorneys at Castro & Co. today to schedule a free consultation.


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