The tax treatment of carried interest has long been a subject of political debate. Since 2007, almost annually, the taxation of carried interest has found its way into either proposed legislation or presidential budget proposals. Most recently, on February 6, 2025, US President Donald Trump had discussions with Republican leadership while Democratic leadership reintroduced legislative proposals to treat carried interest as ordinary income.
In Depth
OVERVIEW OF CARRIED INTEREST
Private investment fund sponsors typically receive management fees (based on a specified percentage of the fund’s capital commitments) and carried interest. Frequently referred to as a “loophole,” carried interest is a contractual right that qualifies as a “profits interest” for tax purposes, entitling the sponsor to a share of the gain recognized by an investment fund. Like any other partner, the character of the income or gain allocated to the sponsor with respect to carried interest is determined based on the character of the income or gain recognized by the fund. If the sponsor’s carried interest is attributable to qualified dividend income or, subject to the limitations imposed under Section 1061 of the Internal Revenue Code, long-term capital gain recognized by the fund, the sponsor is eligible for favorable federal income tax rates (generally at a 23.8% federal income tax rate).
SECTION 1061 AND THE 2021 TREASURY REGULATIONS
Enacted in 2017 as part of the Tax Cuts and Jobs Act, Section 1061 recharacterizes certain gain that would otherwise qualify as long-term capital gain with respect to “applicable partnership interests” as short-term capital gain. An applicable partnership interest is any interest in a partnership that, directly or indirectly, is transferred to – or is held by – a taxpayer in connection with the performance of substantial services by that taxpayer, or any other related person, in any applicable trade or business. Under Section 1061, a three-year holding period (instead of the typical one-year holding period) generally is required for a carried interest holder to qualify for long-term capital gains treatment.
PRIOR CARRIED INTEREST PROPOSALS
Prior to the enactment of Section 1061, several carried interest recharacterization bills and other similar legislative proposals were considered by US Congress. Beginning in 2007, many bills proposed to tax all or a portion of income earned by fund sponsors from carried interest as ordinary income. One set of proposals would have applied solely to funds engaged in investment or real estate activities while a broader set of these proposals would have applied to carried interest from any fund, regardless of the fund’s activities.
Various proposals sought to treat certain net income derived from, and gain on the disposition of, an “investment services partnership interest” as ordinary income. This would have subjected the income and gain to a higher tax rate and self-employment taxes. These bills generally defined an “investment services partnership interest” as a partnership interest held by any person in connection with the conduct of a trade or business that involves certain investment activities, which would include most fund sponsors.
Since the enactment of Section 1061, Congress has continued to consider the federal income tax treatment of carried interest. Notably, as part of the deliberations over what became the Inflation Reduction Act of 2022, Congress considered further limiting long-term capital gain eligibility for carried interest by, among other things, increasing the required holding period from three to five years.
CURRENT CARRIED INTEREST LEGISLATION PROPOSALS
On February 6, 2025, President Trump met with Republican leadership and discussed including the elimination of preferential tax treatment for carried interest in a list of priorities he wants to accomplish in this year’s tax bill. While President Trump previously called for ending capital gains eligibility for carried interest in his 2016 campaign tax reform, the Tax Cuts and Jobs Act of 2017 only tightened eligibility requirements by enacting Section 1061.
On the same day President Trump discussed ending the carried interest preferential treatment, Democratic leadership proposed new bills that would treat carried interest as compensation (taxed at ordinary income tax rates and subject to self-employment taxes), eliminate the preferential tax treatment of qualified dividends, and eliminate the exclusion for gain from the sale of qualified small business stock, in each case, to the extent realized with respect to an investment services partnership interest.
The Trump administration’s policy on carried interest has not yet been fully defined and current bills on the tax treatment of carried interest are in the beginning stages of the legislative process, so it remains to be seen whether carried interest holders’ eligibility for preferential tax rates will be further curtailed or eliminated altogether.
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