Deferred Interest/Promote in 2022: Action Items for Investing, Private Equity and Real Estate Fund Managers | Jackson Lewis CP

Managers of investment funds, private equity and real estate should consider familiarizing themselves with the complex final regulations on the preferential tax treatment of “carried interest” under Section 1061 of the Internal Revenue Code (Code) which are generally effective for taxation years beginning on or after January 1, 2022.

Preferential treatment of carried interest

Frequently referred to as a “promote” in the real estate investment trust industry, a “deferred interest” is a profit interest in an investment-oriented partnership or limited liability company taxed as a partnership for the purposes of federal income tax (each, an “Investment Pass-Through Entity”) held by the manager providing investment management services to such entity for a fee (fund manager) (for example, the general partner of the general partnership or the managing partner of the limited liability company).

For the fund manager, the main benefit of a deferred interest/promotion is the preferential federal tax treatment on distributions from the investment transfer entity: if the assets of the investment transfer entity are held for the required holding period (currently, more than three years; prior to 2018, more than one year), the gains from the sale of these assets are transferred to the fund manager — and, by extension, to the fund manager’s employees. funds directly or indirectly, through the Fund Manager, holding interests in the Investment Transfer Entity – as capital gains, rather than as gains subject to ordinary income tax. Accordingly, in return for providing investment management services to the Channeling Entity, the Fund Manager (and its employees with direct or indirect interests in the Channeling Entity) receive investment income, taxed at a capital gains rate of up to 23.8%, rather than compensation income, taxed at an ordinary tax rate of up to 37%.

Tax Cuts and Jobs Act

In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), which was signed into law by President Donald Trump. The TCJA attempted to curb the deemed preferential treatment of carried/promoted interest by requiring that assets held by the investment transfer entity be held for more than three years (instead of more than one year) in order to that capital gains are triggered by the sale of those assets (and passed on to the general partner or managing member, as the case may be) to benefit from the treatment of long-term capital gains.

Code Section 1061, the carried/promoting interest status added by the TCJA, only applies to an “applicable partnership interest” (API). The law generally defines an API as an interest in a partnership (including a limited liability corporation taxed as a partnership for federal income tax purposes) that qualifies as an “applicable trade or business” that directly or indirectly, is transferred to (or is held by) a taxpayer in connection with the provision of substantial services by the taxpayer.

An “applicable business or business”, in turn, generally means a business engaged, on a regular, continuous and substantial basis, in raising or repaying capital. and That is:

  1. Invest in (or dispose of) specified assets (or identify specified assets for such investment or disposal); Where
  2. Develop such assets.

Investment Transfer Entities will generally be considered applicable transactions or activities. Therefore, unless an exception applies, interests carried/promoted held by the fund manager (and its employees holding stakes therein) will generally qualify as API subject to the holding rule of more than three years (API holding rule).


The law provides for three exceptions. First, in certain circumstances, the API holding rule does not apply to income or gains attributable to any assets not held for portfolio investment purposes on behalf of third-party investors.

Second, an API does not include (therefore the API holding rule does not apply to) an interest in a partnership (or a limited liability company taxed as a partnership for the purposes of federal income tax) held directly or indirectly by a corporation.

Third, an API does not include certain capital interests.

Final settlement

In January 2021, the Treasury Department issued the final rule under Code Section 1061. This final rule (which followed the draft rule published in July 2020) clarified the requirements for applying the capital interest exception, required loans made by partners or members of the transfer entity. investment to employees seeking to purchase capital interest therein to bring personal responsibility for the employee (while prohibiting loans from the investment transfer entity itself), reduced “transparency” with respect to API sales, under which APIs held for more than three years could be subject to short-term capital gains treatment (generally ordinary tax rates would apply) and clarified the scope of the law with respect to transfers of APIs to related persons .

Action Items

The final settlement is complex. From the perspective of a fund manager seeking to incentivize its key employees/shareholders with respect to stakes/promotions and equity stakes in investment transfer entities, consideration should be given to taking the following measures in 2022:

  1. Determine if the investment transfer entities are applicable businesses or businesses. One cannot have an API unless the interest is held in an applicable trade or business. A key determination is whether Investment Transferring Entities are engaged in activities that would otherwise give rise to applicable business or commercial status on a “regular, continuous and substantial basis”.
  1. Inventory the sales history of assets held by investment transfer entities. If assets held by Investment Transfer Entities are typically held for more than three years (which is often the case in real estate development and investment), Code Section 1061 should not be applicable. such an important issue.
  1. Review partnership agreements and operating agreements in connection with the granting of equity investments. The Final Rule generally requires equity interests to receive allocations determined and calculated in the same manner as allocations for equity interests held by non-service partners and similarly situated members who have made equity contributions. important aggregates.
  1. Structuring Loans to Acquire Equity Investments Carefully. Few key employees will be satisfied with a loan from an associate or member with personal liability. (The requirement extends to loan guarantees.) In addition, loans from investment transfer entities themselves are prohibited. In applying these rules, certain concepts of “related person” apply.
  1. Review the holding period of API sales held over three years. The Final Rule recategorizes the holding period to three years or less if: (1) the holding period does not include any period prior to when a partner or unrelated member not providing substantial services to the Transferring Entity Investment Transferee becomes legally obligated to contribute cash or property to the Transferring Entity; or (2) the sale of the API is part of a transaction or series of transactions the primary purpose of which is to avoid the application of Code Section 1061.

Deferred interest/promotional tax rules require careful planning and, almost always, expert legal analysis applying Code Section 1061 and the Final Rule to the particular facts. This analysis is perhaps even more important when dealing with general partnerships and limited liability companies.

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