Starting on page 191, the recently passed Senate Tax Bill would bring some change to the taxation of carried interest. The Senate Tax Bill would insert into the IRC a new Section 1061 – Partnership Interests Held in Connection with Performance of Services. This new section provides that, for applicable partnership interests, capital gains previously classified as long-term will be treated as short-term capital gain unless the gains were generated from assets held for more than three years. Short-term capital gains are subject to marginal federal income tax rates, including the Medicare surtax, approximating 43.4%. In contrast, current law allows performance allocations (carried interest) generated from the sale of assets held for more than one year to maintain treatment as long-term capital gains, which are taxed at the more favorable marginal federal tax rate, including the Medicare surtax, of 23.8%. A near 20-point increase in the effective tax rate is implied for carried interest generated from gains on sales of assets held between one and three years.

The Senate Bill will likely affect a small percentage of hedge funds that have longer-term investing strategies (e.g., activist investors that take large positions and seek change through board representation or otherwise), and a meaningful percentage of private equity deals that are harvested in less than three years. A recent Bloomberg article stated that approximately 24% of private equity deals are sold within three years. Some commentators have suggested that the new section does not go far enough, leaving room for most private equity carried interest to maintain treatment as long-term capital gain. That is a policy debate that will be left for a different audience at a different time. It is clear that if the Senate Tax Bill’s new Section 1061 is ultimately adopted in final legislation, many hedge fund and private equity managers will be meaningfully impacted.

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