Historically, many fund managers have received an allocation of fund profits in connection with positive fund performance. As an allocation of fund profits, this “incentive fee” retains the character of the income and gains earned by the fund. Thus, in exchange for services resulting in positive fund performance, fund managers may be compensated with long-term capital gains that are taxed at favorable rates, so long as the property generating the gain was held for at least one year.

The Tax Cuts and Jobs Act

On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA). Among many other significant tax provisions, the TCJA added Section 1061 to the Internal Revenue Code, requiring long-term gains connected to carried interest to be reclassified as short-term when the property that created the gain was held for less than three years. Thus, the traditional one-year holding period requirement to receive the preferential long-term gain treatment, was extended to three years for fund managers.

Final treasury regulations issued January 7, 2021

As part of the final U.S. Treasury regulations released in January 7, 2021, many fund managers are offered significant relief from the three-year holding period requirement in the form of the “capital interest exception.” (While the capital interest exception was included in the original law, previously published proposed regulations limited a fund manager’s ability to use the exception.)

Now, allocations in connection to the portion of the fund manager’s interest in the fund that are commensurate to the manager’s invested capital are exempted from the three-year rule. So, fund managers must bifurcate their interest in the fund between (a) the portion subject to the three-year holding period, and (b) the capital interest.

Final regulations provide that for an interest to be included as capital interest, it must:

  • Be previously taxed capital
  • Be clearly described in the partnership agreement
  • Be clearly separated in the partnership books and records
  • Receive allocations in a similar manner to the interest of an unrelated, non-service partner

By complying with these rules, managers can move the maximum portion of their interest into the capital interest bucket (and the one-year holding period requirement) without the need to distribute and re-contribute cash.

Capital interest exception checklist

Fund managers should act in conjunction with legal counsel, tax advisors, and fund administrators to maximize their capital interest exception, and minimize their exposure to higher tax rates now, and in the future. The following brief checklist may be helpful as you establish a plan of action:

  • Analyze GP capital account to separate capital eligible for the capital interest exception – Tax Advisor
  • Amend partnership agreement to clearly describe the capital interest – Legal Counsel
  • Clearly separate the capital interest in the fund’s books and records – Fund Administrator
  • Ensure allocations to the capital interest are made in a similar manner to unrelated/non-service partners – Legal Counsel

UMB Fund Services is a national leader with decades of experience in registered and alternative investment fund servicing. Visit our website to learn how UMB Fund Services can support your firm, or contact us to be connected with a fund services team member.

When you click links marked with the “‡” symbol, you will leave UMB’s website and go to websites that are not controlled by or affiliated with UMB. We have provided these links for your convenience. However, we do not endorse or guarantee any products or services you may view on other sites. Other websites may not follow the same privacy policies and security procedures that UMB does, so please review their policies and procedures carefully.