Private equity fund managers face some unique tax challenges, especially when it comes to carried interest. The good news is that savvy managers may be able to lower taxes with proactive planning.

Mitigation Tactics

Most fund managers receive a partnership interest in the fund’s general partner. As a result, they receive a share of the profits on the disposition of a fund asset, after the limited partners have been reimbursed for their investments and any hurdle rate is met. Below are four possible strategies for fund managers to consider to minimize the tax hit on carried interest:

1. Optimizing capital gains holding periods. It’s critical to pay attention to the holding period when disposing of a fund asset, especially when a follow-on investment was made to an existing portfolio company and different blocks of stock have different holding periods. Under the Tax Cuts and Jobs Act of 2017, carried interest is subject to long-term capital gains treatment only if the underlying investment is held for at least three years. If the minimum holding period isn’t satisfied, carried interest will be subject to ordinary income tax rates. The difference can be significant. The maximum ordinary income tax rate is currently 37%, compared to 20% for long-term capital gains. The 3.8% net investment income tax may also apply.

2. Deferring taxable income through carried interest waivers. A carried interest waiver provides a mechanism for obtaining long-term gains treatment on carried interest from the disposition of investments held for less than the minimum holding period. With a waiver, the carried interest holder elects to forego the gain on the carried interest in exchange for additional carried interest on other investment assets held for at least three years by the fund. While the IRS has suggested that such waivers may not be respected under federal income tax law, the final regulations for the three-year holding period requirement do not address the issue.

3. Using estate planning tools. Several strategies for transferring wealth in a tax-efficient manner can be applied to carried interest, particularly when it’s transferred before the fund begins investing. For example, you can remove carried interest from your estate by transferring it to a grantor-retained annuity trust (GRAT). You’ll typically receive an annuity payment over a term of years that totals the value of the transferred interest, so no taxable gift occurs. Any appreciation at the end of the term — often substantial for carried interest — transfers to the GRAT’s beneficiaries tax-free and is excluded from your taxable estate (assuming you survive the term). Family limited partnerships can offer another tax-efficient option for transferring carried interest.

4. Relocating from high-tax states. Private equity fund managers who live in states with high income taxes, such as New York or California, might consider moving to states with more favorable tax treatments for carried interest. Alternatively, a manager could establish a nonresident trust to hold carried interest in a state without individual income taxes, such as Florida, Nevada, South Dakota, Tennessee, Texas or Wyoming.

Carried Interest in the Crosshairs (Again)

The capital gains tax treatment of carried interest has been the subject of bipartisan criticism for years. In fact, President Trump recently has indicated that he would like to eliminate its capital gains treatment. It’s possible that upcoming federal tax legislation could include provisions that treat carried interest as wages, making it subject to ordinary income taxes and payroll (or self-employment) taxes. Fund managers may want to review their fund agreements to determine if they allow for revision if the taxation changes.

We can help you stay atop the latest developments on this issue. Our private client services group can help devise strategies to limit your tax obligations from carried interest. Fill out the form below and we’d be happy to connect you with the right person.