How Tax Reform’s Carried Interest Provision Could Impact 2017 Year-end Planning for Hedge Funds– December 22, 2017 by Cynthia Pedersen

On December 22, 2017, President Trump signed into law sweeping tax reform that will generally be effective for taxable years beginning after December 31, 2017. However, the bill’s carried interest provision may directly impact fund managers’ year-end planning now, particularly hedge fund managers.
 
There has been criticism in the press that the carried interest “loophole,” which allows an allocation of long-term capital gains to general partners (GPs), was not closed in this legislation. However, the legislation does create a new tax code section that may cause the incentive allocation for some funds to be considered as short-term capital gain to a GP. Specifically, this treatment would apply when an interest in a partnership is directly or indirectly transferred to a taxpayer (general partner) in connection with the performance of services for an investment fund and changes the required holding period to have long-term capital gain on the allocation from one year to three years.
 
These provisions may have a minimal impact to private equity, real estate funds managers and certain long-term investment funds, as these funds generally will hold assets for a longer period of time. Additionally, these provisions also appear to minimally impact limited partners of funds, as the three-year holding period rule only will apply to partners providing services to the partnership. However, the rules may have an impact to some hedge funds managers who do not annually distribute their incentive allocation or do not regularly holds assets for more than three years. 

Planning Opportunities

At this point, we expect that there will be clarifying regulations, possible technical corrections and further interpretations to provisions in the legislation. However, there appears to be some planning opportunities that fund managers may want to consider before the end of 2017 to potentially minimize some consequences of this bill. This update is not intended to provide investment advice, and managers should consider their own facts and circumstances (including their trading strategy, investor relations and other business factors) and consult with their tax advisors in determining if any of the planning opportunities discussed below are reasonable for their particular circumstances.
 
The action items outlined below are focused on managers who maintain assets between one and three years that otherwise would have recognized long-term capital gain but may be subject to short-term capital gain in future years, pursuant to this new section.
 
Some immediate options to consider before the end of 2017 include: 

  1. Long-term capital gains
    • If the fund currently maintains large unrealized gain stemming from assets held for more than one year but less than three years, the manager may consider recognizing those gains at the lower long-term capital rate in 2017. The incentive allocation to the GP may be taxed a lower tax rate in 2017 than in 2018. Consideration should be given to the impact to limited partners’ tax situations.
    • The manager may consider distributing cash from the fund to the GP to trigger fill-up provisions on any unrealized gain allocated as part of incentive allocation. Owners of a GP may be able to reinvest personally back into the fund. Again, limited partners’ tax situations may be impacted.
    • GPs should consider recontributing the cash to the fund or a different fund with specific tax considerations.
    • The manager may consider changing the lot identification method to achieve desired tax outcomes, e.g., specific lot identification versus LIFO or FIFO.
    • GPs and LPs should consider their personal tax impact and potentially pay state and local tax expenses before year-end. The tax legislation limits these deductions for tax years after 2017.
  2. In-kind distributions to the GP. Depending on the assets held by the fund a distribution in kind may allow a deferral of gain recognition until such time that the asset is disposed by the manager. The GP may also re-contribute these assets to the fund with certain limitations (i.e. diversification and disguised sale rules).   
  3. Conversion of GP interest to an LP interest: The new provision only applies to active interests in the fund; however, it is unclear whether subsequent regulations may consider the carried interest related to unrealized gain allocations or income on reinvested GP interests back to the GP and subject the LP to the extended holding periods. However, converting a GP interest to an LP interest appears to be a simple action that managers may want to consider with little downside or risk. 

The full impact of the carried interest provision is yet unknown. For example, the application to IRC Section 1256 contracts is unclear at this time. Another strategy managers may want to consider is changing the tax structure of their GP by electing corporate tax treatment, as the tax legislation provides an exception from the extended holding period rule for interest held by corporations. Again, it is unclear as to whether the exception would apply to only C Corporations or if it would also include S Corporations.
 
After year-end, we expect to further communicate directly with our clients on their specific situations. If you have questions now, we encourage you to reach out to your tax team for guidance. You can also contact Cynthia Pedersen at cynthia.pedersen@cohencpa.com or Rob Velotta at rvelotta@cohencpa.com
 

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.