Interest carried over / Promotion in 2022: Elements for investment, private equity, real estate fund managers

Managers of investment funds, private equity and real estate should consider familiarizing themselves with the complex final provisions on preferential tax treatment of “transferred interest” under section 1061 of the Internal Revenue Code (Code), which are normally in force for tax years beginning on or after 1 January 2022

Preferential treatment of transferred interests

Often referred to as “promotion” in the real estate investment fund industry, “interest transferred” is interest on profits in an investment partnership or a limited liability company taxed as a partnership for federal income tax purposes (each, “investment interest”). “through entity” pass) held by the manager providing investment management services to such entity for remuneration (fund manager)eg, the unlimited partner of the company or the manager of the limited liability company).

For the fund manager, the main advantage of the transferred interest / promotion lies in the preferential treatment of federal income tax on distributions by an investment transfer: If the assets in the investment transfer are held for the required holding period (currently more than three years; 2018, more than one year), the profits from the sale of such assets are transferred to the fund manager – and in addition to the employees of the fund manager directly or indirectly, through the fund Manager holding shares in the transferred investment company – as equity profits and not as profits subject to ordinary income tax. Accordingly, in return for the provision of investment management services to the Investment Transfer Enterprise, the Fund Manager (and its employees holding direct or indirect holdings in the Investment Transfer Enterprise) receive investment income taxed at a rate of return on equity of up to 23.8%, not compensation income subject to a simple income tax rate of up to 37%.

Tax and Employment Reduction Act

In 2017, Congress passed the Tax and Job Reduction Act (TCJA), which was signed by President Donald Trump. TCJA has attempted to control the alleged preferential treatment of transferred interest / promotion by requiring assets held by the investment transferor to be held for more than three years (instead of more than one year) in order to trigger capital gains by selling such assets (and transferred to the general partner or managing member, as appropriate) to qualify for long-term capital gains.

Section 1061 of the Code, the transferred interest / promotion status added by TCJA, only applies to “applicable partnership participation” (API). The statutes generally define the API as participation in a partnership (including a limited liability company taxed as a partnership for the purposes of federal income tax), classified as “applicable trade or business”, which is directly or indirectly transferred to (or held by) ) a taxpayer in connection with the provision of essential services by the taxpayer.

“Applicable trade or business”, on the other hand, usually means a business engaged regularly, continuously and to a significant extent in raising or returning capital and or:

  1. Investing in (or disposing of) certain assets (or identifying certain assets for such investment or disposal); or
  2. Development of such assets.

Investment transfer companies are usually classified as applicable transactions or businesses. Accordingly, unless an exception applies, transferred units / promotions held by the fund manager (and its employees holding units in the fund) will normally qualify as an API subject to the rule for more than three years (Holding rule). of the API).


The statute provides for three exceptions. First, in certain circumstances, the API Holding Rule does not apply to income or profits attributed to assets that are not held for portfolio investment on behalf of third-party investors.

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

Third, the API does not include certain capital interests.

Final rules

In January 2021, the Ministry of Finance issued final provisions under Section 1061 of the Code. These final provisions (which follow the proposed regulations issued in July 2020) clarify the requirements for applying the capital interest rate exemption, the loans required from partners or members of the investment transfer company to employees wishing to purchase equity interests in them. to carry personal responsibility for the employee (while prohibiting loans from the transferring undertaking itself), reduce the “review” of API sales where APIs held for more than three years may be subject to short-term capital gains treatment, ordinary taxes will normally apply on income) and clarifies the scope of the statutes regarding the transfer of APIs to related parties.

Elements of action

The final rules are complicated. From the point of view of a fund manager who seeks to stimulate his key employees / shareholders with regard to transferred interests / also promotes capital interests in investment transferring entities, the following actions should be considered in 2022:

  1. Determine whether the entities to be transferred are applicable transactions or businesses. One cannot have an API unless the interest is in applicable trade or business. A key determination is whether the Investment Transferring Entities engage in activities that otherwise give rise to applicable commercial or business status on a “regular, continuous and substantial basis”.
  1. Inventory of the history of sales of assets held by transferred investments. If the assets held by the transferees are usually held for more than three years (often the case of real estate and investment space), section 1061 of the Code should not be such a big problem.
  1. Review partnership agreements and operational agreements related to the provision of capital contributions. Final rules usually require capital shares to receive distributions determined and calculated in a similar way to distributions in respect of shares held by similarly related unrelated partners and members who have made significant aggregate capital contributions.
  1. Carefully structure loans to acquire capital interests. Few key employees will be happy with a loan from a partner or member with personal responsibility. (The requirement also covers loan guarantees.) In addition, loans from the investment transferring entities themselves are prohibited. In applying these rules, certain terms of “related party” apply.
  1. Examine the retention period of API sales held for more than three years. The final provisions shall recategorize the holding period of three years or less if: (1) the holding period does not include the time before the unrelated partner or member who does not provide essential services to the Investment Transferor becomes legally obliged to contribute cash or property to the Investment Transferred Person; or (2) the sale of the API is part of a transaction or series of transactions whose primary purpose is to avoid the application of Section 1061 of the Code.

The transferred interest / promotion tax rules require careful planning and almost always expert legal analysis, applying section 1061 of the Code and the Final Provisions to the specific facts. This analysis is perhaps even more important when multilevel partnerships and limited liability companies are involved.

Jackson Lewis’ attorneys can help you navigate these complex rules and structure compensation agreements that comply with these rules, including exceptions.

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