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Internal Revenue Code Section 1061 Proposed Regulations – Pirates of the Carried Interest


Introduction

During the time when pirates ruled the Caribbean seas, sellers of goods needed safe transportation to travel the seas in order to reach purchasers of those goods. The fees that the pirates, such as Captain Jack Sparrow, were paid came in two forms. The first was a flat fee for safe transportation to the destination. The second fee was a percentage on the gross sales revenue paid to the sellers. This second fee was known, in the pirate world, as “carried interest”, as it was above and beyond the fee paid for safe transportation. It was a percentage based on protecting those goods that the pirates “carried to safety”, away from other fiends and scoundrels once both parties completed the sale.

The notion of “carried interest” has been a part of the tax code for many years. It is typically used in the context of hedge funds where the managers receive a flat fee, treated as ordinary income, and then an additional amount, based on a percentage (internal rate of return), treated as long-term capital gain (“LTCG”). Many critics have noted the disparity between the treatment of hedge fund managers vs. investment bankers. For investment bankers, the percentage received is subject to ordinary income rates as opposed to LTCG rates. Such critics argue for the elimination of capital gain rates for hedge fund managers in order to tax such managers in a manner similar to investment bankers.

In 2017, the Tax Cuts and Jobs Act (“TCJA”) was passed by Congress and signed into law by the President. The Internal Revenue Code (“IRC”) addressed the issue of carried interest in the newly enacted Section 1061. The purpose of Section 1061 was to alter the differences in treatment of income as ordinary vs. capital gain as described above. Section 1061 imputes a holding period of three years before gain allocated to certain carried interest arrangements can be subject to the more favorable LTCG rates.

LTCGs are subject to tax at a maximum rate of 23.8%, which consists of the LTCG rate of 20% plus the 3.8% net investment income tax (“NIIT”), if applicable. It is prudent to note that ordinary income, as well as short-term capital gains, are subject to the 37% maximum rate. If NIIT was applicable, such income would be subject to the maximum rate of 40.8%.


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