Carried interest solutions for hedge fund managers
Many hedge fund managers are feeling the impact of the 2017 tax reform for the first time this season. The Tax Cuts and Jobs Act of 2017 (TCJA) carried interest rules impose a longer holding period for access to long-term rates for many general partners.
In the past, a large portion of a hedge fund manager’s income could be taxed as long-term capital gains. Following the passage of the TCJA, in order to achieve the long-term tax rates on their incentive fees, hedge fund managers must hold investments for three years – previously this was a one-year requirement.
Now faced with the reality of a longer holding period to benefit from long-term rates and ultimately a much more significant tax burden, hedge fund managers should consult their tax advisors to evaluate how best to move forward given this new requirement and create a plan. Some potential strategies to consider, include:
- Hold investment property: The long-term capital gain treatment did not change for any investment held for three years or more.
- GP capital account bifurcation: Hedge fund managers are able to divide their capital account into two parts: contributed capital and incentive fees. The portion of the capital account commensurate to contributed capital is not subject to the new holding period requirement. While this may be a time-consuming option, it could be advantageous to reduce impact and allow for pre-tax savings.
- Distribute property in-kind: Property distributed in-kind can be sold by the general partner, outside of the partnership, without being subject to the new holding period.
- Clear tainted capital: Hedge fund managers are finding a variety of strategies for clearing the taint of a capital account subject to the new holding period. Most of these strategies involve some combination of a taxable event, redeeming capital, and re-contributing the capital as a limited partner’s interest.
These are just a few of the most popular strategies being implemented by hedge fund managers and their tax advisors. Keep in mind that this holding period change impacts all of a fund manager’s incentive fees accumulated in the fund – regardless of when the fee was earned, or whether the fee was previously taxed.
It is important to engage with tax advisors to plan for reducing future impact and to understand all the options available given a fund’s structure, strategy and investments. Fund administrators with dedicated tax services could be particularly helpful in this process as they have practical plans that are based on their intimate understanding of alternative investments and the regulations and tax law that impact these products.
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