THE TAXATION OF CARRIED INTEREST AND ITS EFFECTS UPON CITIES.

• Author: Ferrone, Joseph

Introduction I. Carried Interest: An Overview A. Carried Interest and I.R.C. Section 1061 B. Private Equity Funds C. Hedge Funds II. The Great Tax Debate A. The Critics of the Preferential Tax Treatment of Carried Interest B. The Proponents of the Current Carried Interest Tax Law III. Moderate Reform and Its Importance to Urban Areas A. Section 1061: A Balancing Act . B. New York City: The Private Investment Funds Capital Conclusion . INTRODUCTION

As the adage goes, in this world, nothing can be said to be certain, except death and taxes. Although this invariably proves to be true, tax reform remains a central aspect of every election. With the 2020 election approaching, the public should expect to hear more about the taxation of carried interest, as it remains a major point of controversy within the world of tax law. (1) Specifically, carried interest is a portion of the profits of a private investment fund that is distributed to fund managers as compensation for a fund reaching a certain threshold of profitability. (2) Controversially, if fund managers hold the underlying asset for a minimum of three years, the resulting carried interest is currently taxed as a long-term capital gain at a maximum rate of 20%. (3) If fund managers hold the underlying asset for less than this three-year holding period, the resulting carried interest is taxed as a short-term capital gain at a rate of approximately 40%. (4) Yet, commentators claim all carried interest should be taxed as ordinary income, which is taxed at a maximum rate of approximately 40%. (5)

President Donald Trump made fixing this "tax loophole" a central promise of his 2016 campaign. (6) Despite passing ground-breaking tax reform in the 2017 Tax Cuts and Jobs Act, however, the carried interest loophole remains largely untouched. (7) The only significant reform occurred in Section 1061 of the Internal Revenue Code, which increased the holding period requirement from one year to a minimum of three years, in order for carried interest to qualify for long-term capital gains tax treatment. (8) Not surprisingly, private investment fund managers have utilized and designed various structures to circumvent this requirement. (9) Moreover, even under the assumption that the Internal Revenue Service (IRS) would challenge such structures, the three-year holding requirement does not affect hedge fund or private equity fund managers. Specifically, hedge funds generally hold assets for less than one year, so carried interest distributed to hedge fund managers was not receiving preferential long-term capital gains tax treatment under the previous law. (10) Furthermore, private equity funds generally hold assets for far longer than three years, making Section 1061 ineffective for private equity fund managers. (11)

Although arguments present strong points in favor or against amending the relevant laws, carried interest should not be taxed solely as a long-term capital gain or as ordinary income. Specifically, Section 1061 should be tightened to more effectively limit the ability of fund managers to gain long-term capital gain tax treatment, but also allow such treatment in certain circumstances. An increase in the minimum holding period requirement from three years to a five-to seven-year period, an expansion in the definition of "related parties," and bringing other types of investments into its purview would make Section 1061 more effective. This additional tax revenue would amount to billions of dollars and would have a significant effect on many indebted urban areas. (12) Yet, legislators must keep in mind that private investment funds bring jobs, philanthropic endeavors, and economic growth to American cities, especially New York City. (13) Thus, a properly drafted revision should continue to incentivize fund formation and allow private investment funds to continue to help urban economies thrive.

Part I of this Note provides an overview of carried interest and analyzes Section 1061's stipulations and its resulting industry-wide effects with a focus on hedge funds and private equity funds. Part II discusses the arguments in favor of and against taxation of carried interest as a long-term capital gain. Part III argues that carried interest should not be taxed solely as a long-term capital gain or as ordinary income, and that Section 1061 should be altered to further limit such preferential tax treatment while properly incentivizing fund formation. Part III concludes by illustrating how a properly drafted revision to Section 1061 is significant to New York City.

1. CARRIED INTEREST: AN OVERVIEW

   A. Carried Interest and I.R.C. Section 1061

   Carried interest is the primary means by which private investment fund managers are compensated. (14) Private investment funds are typically organized as limited partnerships with investors as the limited partners and fund managers as the general partners. (15) The fund managers determine investments that the fund makes, and the fund generates gains or losses through the operation of the investments made by fund managers. (16) As per partnership tax law, the resulting gains or losses flow through to the partners. (17) Carried interest is distributed to fund managers if the fund reaches a certain threshold of profitability. (18) If fund managers do not hold the underlying investment for a minimum of three years, the resulting carried interest is being taxed as a short-term capital gain at a maximum rate of approximately 39.6%. (19) However, if fund managers hold the underlying investment for a minimum of three years, the resulting carried interest is currently taxed as a long-term capital gain at a maximum rate of 20%. (20) In response to critics, the Tax Cuts and Jobs Act addresses this issue in I.R.C. Section 1061. (21) Tax planning strategies and the general nature of certain private investment funds reveal that Section 1061's new three-year holding period requirement is relatively ineffective. (22)

   Hedge fund and private equity fund managers are some of the wealthiest people in the world. (23) The taxation of their compensation arrangements is an area of constant debate and a major controversy in tax law. (24) Private investment funds typically follow what is known as a "two and twenty" compensation structure. (25) The 2% refers to the minimal portion of their income that is composed of a management fee. (26) Specifically, this annual management fee is guaranteed in the partnership agreement and is taxed as ordinary income. (27) The 20% refers to the portion of a fund manager's income that is deemed a profits interest. (28) The profits interest is not guaranteed, as it is incentive-based. (29) Under a typical arrangement, a fund manager usually sets a certain threshold of profitability that he must surpass and, upon reaching the threshold, is able to garner a share of the profits. (30) Subject to some slight restrictions, this profits interest can be taxed as a long-term capital gain at a maximum rate of 20% with an additional 3.8% surtax of net investment income tax. (31) For example, if a private investment fund manager formed a fund and investors made an initial total investment of $1,000,000, under a two and twenty compensation structure, the manager would be allocated a management fee of 2% or $20,000. (32) If the fund performs over a designated threshold, such as a profit of $500,000, the manager would get 20% of the profit or $100,000. (33)

   Since some investment funds invest relatively aggressively, these fees can reach extraordinarily high amounts, but such aggressive investments also run the risk of generating losses for investors. (34) The preferential tax treatment of carried interest is so significant that investment fund managers often forfeit a portion of their annual management fee in exchange for a higher amount of carried interest. (35) These fee waivers have become very common and allow fund managers to forego the typical 2% management fee that would be taxed as ordinary income. (36) Instead, these fund managers can, therefore, earn a higher rate of carried interest with its potential tax benefits. (37) Moreover, since fund managers typically invest their own money into the fund, the profits distributed based upon a fund manager's invested capital is often treated as a capital gain, subject to some slight restrictions. (38)

   Due to the significant amount of wealth involved, a constant debate surrounds the preferential tax treatment of carried interest. (39) Proponents of the preferential tax treatment claim that carried interest is based upon the vicissitudes of the markets and is not guaranteed, making long-term capital gains treatment most logical. (40) Moreover, these proponents rely on other various taxation-based arguments and public policy rationales. (41) On the other hand, critics of the current tax treatment of carried interest liken carried interest to a bonus, and affirm that it most logically should be taxed as ordinary income at a maximum rate of approximately 40%. (42) Similarly, these critics rely on a variety of other taxation and public policy-related arguments. (43)

   Congress has previously attempted to reform the taxation of carried interest. (44) These proposals have ranged from the full taxation of carried interest as ordinary income to approaches categorizing carried interest as a blend of ordinary and capital gains income. (45) In 2007, Representative Charles B. Rangel introduced a tax reform bill--H.R. 3970--that would have been included in the Temporary Tax Relief Act of 2007. (46) Specifically, this bill proposed I.R.C. Section 710, which would have effectively changed the taxation of any "investment services partnership interest." (47) The proposed Section 710 would have treated the distributive share of carried interest as compensation income and, therefore, would have taxed fund managers at the applicable ordinary income rates. (48)

   Specifically, Section 710(a)(1), as proposed...