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

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

by John Anthony Castro, J.D., LL.M.

Introduction

The 2016 Presidential Campaigns of both Donald J. Trump and Hillary Clinton made closing the so-called “carried interest loophole” one the primary issues of the election. Trump labeled a very standard tax provision as being a loophole for Wall Street and the wealthy that were “getting away with murder.”[1]

Background

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” or "carried interest," that would be taxed as long-term capital gain upon disposition.[2]

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 in an effort to “lean out,” a company going bankrupt would result in layoffs of the entire workforce; it’s the lesser of two evils. The same logic cannot be applied to short-selling firms, but this is not a discussion of public policy.

The New Section 1061

The new Section 1061 increases the required holding period from 1 year to 3 years.[3] 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.[4] This was intentional. There is simply no way this was not intentional because Section 1061’s indirect ownership attribution rules were intentionally limited to only Code section 318(a)(1) rather than the entirety of Section 318 to determine if a person is related, which is extremely comprehensive and would have included indirect ownership through partnerships, corporations, and trusts. It is this author’s opinion that this loophole was specifically lobbied for; an intentional loophole created for the few that knew about it. For that reason and that reason alone, Section 1061 is political theater; it’s a farce easily circumvented with simple planning. In fact, even the IRS recognized it when they issued Notice 2018-18 claiming their intention to promulgate regulations contradicting the plain meaning of the statute. Treasury cannot promulgate regulations that conflict with the plain wording of the statute; read our article on challenging the validity of Treasury regulations by clicking here.

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.

On that note, it's critical to understand the difference between our solution and ideas proposed by others, such as the "loan-contribute-back" strategy whereby the hedge fund loans money that is then contributed back to qualify for the Capital Contribution Exception and the "special allocations" strategy whereby you unreasonably wait 3 years to get paid that still may not qualify for the exception to Section 1061. These other strategies are susceptible to the Step Transaction Doctrine for lack of economic substance. Our solution is based on the plain language of the statute and not subject to any risk since the U.S. Supreme Court has already ruled that Treasury regulations are limited to the plain wording of the statute; read more here.

Contact Our Firm

If you’re an investment manager with a carried interest in a hedge fund, contact our firm today to schedule a free consultation by clicking here to submit your information online and be contacted by our firm.

About the Author

John Anthony Castro, J.D., LL.M., is the Managing Partner of Castro & Co., the author of International Taxation in Plain English as well as International Estate Planning in Plain English, an esteemed graduate of Georgetown University Law Center in Washington DC, an OPM Fellow at Harvard Business School, and an internationally recognized tax attorney with offices in New York, Los Angeles, Miami, Chicago, Dallas, and Washington DC.

[1] https://www.washingtonpost.com/business/economy/carried-interest-reform-is-a-sham/2017/12/01/05fd7646-d608-11e7-95bf-df7c19270879_story.html