What’s a Carried Interest, and Who’s Carrying Who?
Geoffrey Kayton, CPA
03.22.21 | TAX Chat
A carried interest is ownership in future partnership profits, usually granted in return for services. The terms profits interest and promote are commonly used interchangeably to refer to the same concept. When a carried interest is exchanged for services, the recipient usually does not contribute capital. In other words, the funding comes from other members; hence the term carried interest – the other members are carrying the burden of contributed capital. Also, since the interest is in future profits, the exchange is generally not a taxable event.
A carried interest is powerful; it can change the rate at which income is taxed, and the year in which it is reported. Fundamentally, a carried interest is an application of the rules governing transactions between a partner and a partnership. The relationship between a partner and a partnership can take several forms, generally, that of a vendor, owner, or service provider. Since a carried interest is usually granted to a service provider, we will cover that in more detail.
In general, transactions between a partnership and a service-providing partner are treated as either guaranteed payments or distributive share. Guaranteed payments are associated with cash flow that is fixed (guaranteed), while distributive share is variable and in reference to partnership operations (not guaranteed). Guaranteed payments are taxed as ordinary earned income. Although a distributive share can also be taxed as ordinary earned income, more favorable treatment applies to many of its classifications (i.e., character).
A distributive share from a carried interest will generally match the character as determined by the partnership. An exception to the general rule converts certain long-term capital gains to short-term, increasing the tax rate by 17%. The exception is only applicable to investment-type businesses (including real estate) and only where a carried interest exists. For these investment-type businesses, the long-term holding period is extended from one year to three. Regardless of the business type, business-use assets (as opposed to capital assets) are not subject to the elongated holding period or gain conversion.
Assuming maximum federal marginal rates, tax on distributive share/guaranteed payments can range from 23.8% to 40.8%; a difference of 17%. The types of tax and rates involved:
- Ordinary income tax (currently 37% max)
- Net investment income tax (NIIT) (3.8%)
- Self-employment tax (SE tax) (2.9% as opposed to 15.3%, because at maximum rates, Social Security ceiling applies)
- Additional Medicare tax (0.9%)
- Long-term gain (preferential) rates (20%)
A distributive share of long-term gain is subject to preferential rates and NIIT (23.8%). Allocation of short-term gain is subject to ordinary income tax and NIIT (40.8%). Guaranteed payments are subject to ordinary income tax, SE tax, and Additional Medicare tax (40% – total rate not the sum of the components, because a portion of SE tax is deductible). If the maximum rate applicable to long-term capital gains is increased to the ordinary rate, the spread between these scenarios will become less than 1%. These calculations are very general and isolated to demonstrate key issues, and are not meant to be exact or exhaustive.
Although carried interests can be associated with any line of business, the extended holding period only applies to investment-type businesses and capital assets, which excludes operating businesses and business-use assets. Generally, the fine line between a guaranteed payment and distributive share hinges on the surety of cash distributions. Partnership agreements should be crafted carefully to ensure the best possible tax treatment. If negotiating a new business deal, or analyzing an existing one, your Berdon advisor can help you understand its terms and taxation.
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Geoffrey Kayton is a Tax Manager with more than 10 years of professional experience. He advises a diverse array of clients across the real estate sector on a variety of tax matters.