Gilbert and Sullivan’s Mikado tells the story of Ko-Ko, a tailor and tutor to a beautiful young woman named Yum-Yum, who is also Ko-Ko’s fiancée. Ko-Ko was sentenced to death for flirting but avoided his sentence by being made Lord High Executioner.
Since Ko-Ko is in the front line for the execution, no execution takes place, gaining notice from the Mikado, who decrees that there must be an execution within a month. After Nanki-Poo threatens to kill himself because he can’t have Yum-Yum, Ko-Ko suggests that he execute Nanki-Poo instead. Nanki-Poo agrees to the plan on the condition that he can spend his last married month in Yum-Yum.
The plan falls apart when Yum-Yum learns that upon Nanki-Poo’s execution, she would be buried alive with his corpse – a ban on her. So, instead, Ko-Ko tampers with Nanki-Poo’s execution record and allows her and Yum-Yum to run away together to get married.
The Mikado arrives and all seems well until he sees his son’s name, Nanki-Poo, on the executioner’s records. And to make matters worse, Ko-Ko learns that Nanki-Poo was supposed to marry Katisha. But of course, Nanki-Poo can’t do that now that he’s married to Yum-Yum.
But this being Gilbert and Sullivan, all ends well. Ko-Ko admits that Nanki-Poo is alive (but married to Yum-Yum). And Katisha agrees to accept Ko-Ko, instead of Nanki-Poo, as her husband.
The plot of The Mikado has enough twists and turns to give the viewer a boost. But Congress’ stance on the deferred interest tax has also left observers guessing.
A little over a week ago, in Changes to Tax on Carried Interest Would Lead to Conflicts of Interest, I wrote about a proposal in Congress to change tax laws relating to carried interest. However, now like Ko-Ko, the interest carried may have been given a reprieve. This article discusses the status of tax on carried interest under the bill passed by the Senate and how carried interest should be treated under tax law.
What is the current law?
One of the ways that managers of real estate funds and other funds make money from building up investments is through “carried interest”. To incentivize the managers to manage the investment well, they receive a percentage of the gain when the property is sold.
The manager only receives his payment if the investment is successful. So there is an incentive for the manager to stay with the fund until a successful conclusion. After all, the manager often only gets paid once investors have gotten all their money back, plus a guaranteed “preferred” return similar to interest.
Since a manager may never receive a penny of their deferred participation, it has no value at the start of the investment. Therefore, it is speculative whether a fund manager will ever benefit from its carried interest.
Current law is based on the premise that deferred interest has no value when the fund manager receives it. The value of a carried interest is speculative – it may or may not have value depending on the future performance of the company. Therefore, the interest carried by the manager is assigned a tax base of zero. Accordingly, any amount the Manager subsequently receives as deferred interest has been given capital gain treatment.
Tax law distinguishes capital gains based on how long the investor has owned the asset. If the investor has owned the property for more than a year, it is a “long-term capital gain”. Gains on property held for less time are called “short-term capital gains”.
Short-term capital gains are taxed at the same rates as regular income. But long-term capital gains are taxed at lower tax rates. Taxing long-term capital gains at a lower rate encourages people to save and invest.
Until 2017, capital gains on carried interest were treated the same as other capital gains. However, the Tax Cuts and Jobs Act (“TCJA”) changed that. Now, a property manager or other fund manager must hold the stake for three years before being eligible for long-term capital gains treatment. But investors in the fund get long-term capital gains treatment for investments held for just one year. If real estate or other investment is held for less than three years (for deferred interest) or one year (for investors), the gain is a short-term capital gain taxed at ordinary income rates
What has been proposed?
Interest carried is a frequent target of tax reform. For example, the Carried Interest Fairness Act of 2021 would have eliminated long-term capital gains treatment for carried interest.
Similar text was slipped at the end of the Get the Lead Out Act of 2021, which would have addressed lead pipes in residences. Deferred interest was a target of the Stop Wall Street Looting Act of 2021, which proposed shifting liability from investment firms to private equity and other firms that acquire them. The Small Business Tax Relief Act, proposed in 2022 to reduce corporation tax for small businesses, included a provision for carried interest. Those bills would have eliminated long-term capital gains treatment for carried interest — but none of them made much headway.
However, the Senate Inflation Reduction Act initially included a provision that would have increased the holding period for long-term capital gains treatment for carried interest to five years. However, a last-minute deal removed the deferred interest provision from the Senate bill. So, at least for now, the tax treatment of carried interest will not change.
The “escape” of the carried interest
However, the tax on the interest carried is likely to come back. Treating interest earned as long-term capital gains is seen by many as a tax “loophole” that lines the pockets of already wealthy private equity and hedge fund managers. The term “loophole” implies that the long-term capital gains treatment of carried interest is a tax advantage fabricated by creative lawyers and accountants.
The truth is that the tax treatment of carried interest has long been established under tax law. And just five years ago, when the TCJA was passed, Congress debated the same issue when it increased the withholding period for capital gains treatment of interest from one year to three years.
People may disagree on whether the current tax treatment of carried interest is desirable or whether the law needs to be changed. But whatever one’s belief about what the law should be, there is no ambiguity – and no wealthy fund manager manipulates to circumvent the law. On the contrary, fund managers follow the law passed by Congress.
Comparison of interest paid to stock awards
Those who want all interest earned to be taxed as ordinary income justify this approach by noting that interest earned is compensation for the executive’s services. According to this analysis, carried interest is similar to corporate equity awards or grants to employees.
As part of a compensation package, a company may give employees shares of the company. This stock award or share award, as it is called, will generally be conditional on the employee remaining in place for a specified period of time. After that, the shares vest and the employee can sell the shares subject to legal restrictions.
Stock awards can be considered employee compensation. But like carried interests, they also motivate employees to improve the company’s financial performance in hopes that stock value will increase. Stock awards also encourage employee retention.
Employees have two options for taxing stock awards: they can choose to be taxed on the value of the award when they receive it and have any increase in value upon sale taxed as a capital gain or to pay no tax until they sell the stock and have the sale price taxed as ordinary income.
Equity awards differ from carried interests in that the shares subject to the award generally have discernible value when the equity award is granted. Often there is even a market for the stock, which makes it easier to determine the value. The value of carried interest is speculative since it is based on future events that may never occur.
Everything ended well at the Mikado. However, carried interest will likely be put on the chopping block again – with many hoping for a last-minute reprieve and others cheering the executioner. But for now, carried interest will continue to be eligible for long-term capital gains treatment after a three-year holding period.
This series draws on Elizabeth Whitman’s experience and passion for classical music to illustrate creative solutions to legal challenges faced by businesses and real estate investors.