IRS details reporting guidance on carried interest at partnerships


The Internal Revenue Service provided detailed reporting directions Wednesday for certain passthrough entities and taxpayers reporting partnership interests held in connection with the performance of services, often referred to as “carried interests.”

The guidance comes in the form of frequently asked questions, which are often preliminary to tax regulations. The FAQs contain sample worksheets that certain passthrough entities and taxpayers may be required to use in reporting “carried interests,” partnership interests held in connection with the performance of services for tax returns, filed after Dec. 31, 2021 in which a passthrough entity applies the final regulations.

The IRS recently pledged to make its FAQ process more transparent and allow taxpayers and tax professionals to go back and see earlier versions of the frequently changing FAQ pages in case they need to consult earlier guidance (see story).

The FAQs include additional instructions for certain passthrough entities and taxpayers who, while they are not required to file the sample worksheets, need to provide similar information and must disclose whether the information was determined under the proposed regulations or another method for tax returns filed after Dec. 31, 2021 for a taxable year beginning before Jan. 19, 2021.

IRS headquarters in Washington, D.C.

Andrew Harrer/Bloomberg

The Tax Cuts and Jobs Act of 2017 recharacterized certain net long-term capital gains of a partnership that holds one or more applicable partnership interest, or APIs, as short-term capital gains. The provision generally requires that a capital asset be held for more than three years for capital gains allocated with respect to any API to be treated as a long-term capital gain.

The Biden administration, like the Trump administration before it, had promised to end the tax break on carried interest, which allows fund managers at private equity firms, hedge funds, venture capital firms, and other firms, to pay taxes on their compensation at the lower capital gains tax rate rather than as ordinary income. However, the private equity industry has successfully managed to lobby against ending the tax break substantially, although the TCJA did require assets to be held for at least three years to qualify for long-term capital gains treatment, which is common anyway with most private equity investments. However, the prospect of ending the preferential treatment of carried interest in the Biden administration’s Build Back Better Act prompted concerns in the industry, but the threat appears to have diminished.

“That would certainly be an ongoing tax concern for any private equity fund manager, with carried interest,” said Ryan Guthrie, national practice leader of transaction and business advisory services and national leader of private equity advisory services at BDO USA.

BDO recently polled a group of private equity fund managers about their top concerns for its Fall 2021 Private Capital Pulse Survey and found that 42% of them were most concerned about the impacts of a capital gains tax increase (52%), displacing their top concern in the spring of increased taxation of digital products/services, which fell to the No. 3 spot.

The prospects of an increase in the capital gains tax rate appears to have diminished as well in Democrats’ latest proposals for the Build Back Better Act, who are coming under pressure from moderates in their caucus. “The concern about the capital gains rate increasing really kind of motivated sellers to come to market and fueled this M&A environment,” said Guthrie. “Private equity is obviously in the business of acquiring a lot of businesses and I think that’s where you saw a lot of the fundamentals that are in place really take off. The amount of capital, the aging baby boomer population, etc., really brought a lot of deal activity to the market. There’s still a lot of momentum in the market, which is very good for private equity, and why so many deals are getting completed this year. It goes beyond just the taxes. That’s why you’re seeing so much deal activity globally, so capital gains is less of a concern. I think with private equity there will be some change, and that’s to be expected, but maybe not as large of a tax increase as maybe previously thought on personal returns as well.”

The purpose of the IRS FAQs is to offer guidance relating to both Passthrough Entity filing and reporting requirements and Owner Taxpayer filing requirements in accordance with Department of the Treasury regulations revised in TD 9945 (.pdf).

This updated reporting guidance will also be added to the next revision of Publication 541-Partnerships, which will be released in 2022.

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