How is “carried interest” relevant to hedge fund managers?

We’ve heard a lot of buzz for years now about the “carried interest loophole” that hedge fund managers take advantage of.  Critics of this loophole have suggested that it allows such managers to earn big profits from securities trading without paying taxes.  While there is some truth in the notion that carried interest represents a tax deferral for managers of certain types of investment funds, this is not the case for many managers of true “hedge” funds.

Carried interest defined

As it applies to investment funds, the term “carried interest” itself represents the portion of net gains earned by investment funds that are allocated, versus paid, to the fund manager’s capital account.  While the manager will also earn management fees to cover costs of operating his or her investment advisory practice, the reallocation of investment earnings from the limited partners’ capital accounts to the manager’s or general partner’s capital account represents additional compensation that is contingent on the ability of the manager to generate gains. This reallocation of gains is typically referred to as an incentive or performance allocation, and until the gains are actually withdrawn from the fund by the manager, they continue to be “carried” as capital invested in the fund.

The ”loophole”

For investment funds organized as pass through entities, the tax effect to the manager or general partner of an incentive allocation is a pro-rata share of the entity’s taxable income items.  In the case of private equity or venture capital funds, which make long-term investments that are held for a number of years, the taxation of its gains is deferred until investments are liquidated.  From year to year, these funds may generate only nominal taxable income and expense items; primarily items associated with investment income and annual fund expenses.  When a portfolio investment is sold and a taxable gain occurs, the manager will have taxable income associated with his or her pro-rata capital balance being held as carried interest at that point in time.  Prior to 2018, these allocations were taxed at long term capital gains rates if the investments generating the gains were held for more than a year.

The reality

Hedge funds, however, may invest in any number of investment classes and typically trade in liquid securities versus private companies.  While some may hold all or certain liquid securities for periods of more than one year, it is more common that these funds churn their portfolios much more frequently.  To the extent gains in these funds are generated from buying and selling short-term investments, all of these gains, if any, are going to be currently taxable and are going to be classified as ordinary income taxed at ordinary tax rates as opposed to long-term capital gains rates.

Impact of new tax regulations on carried interest

The Tax Cuts and Jobs Act legislation, effective in 2018, changed the tax treatment of carried interest.  The new law now requires a three year holding period on realized gains for the general partner to receive long-term capital gain treatment.  The greatest impact of this new law is for hedge fund managers who tend to hold investments for more than one year but less than three years.  These managers may want to consider converting part of their general partner interest in the fund to a limited partner interest.  Other possible actions include having the general partner withdraw securities in-kind and, either selling the securities, or distributing the securities to the owners of the general partner and having them then sell the securities.  Alternatively, changing the incentive allocation to a fee is an option but one that would need to be carefully evaluated as to whether it would be beneficial for both the fund manager and the investors.

The bottom line

In the absence of unrealized or “holding” gains on long-term investments being generated within an investment fund, there is no tax advantage on incentive associated performance allocations being earned by fund managers.

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