What is carried interest?
Carried interest represents the profits an investment manager receives, typically from an investment in private equity or a hedge fund (not a mutual fund), in excess of the amount contributed towards the investment. The carried interest functions as a performance fee rewarding the investment manager for enhanced performance. It is not uncommon for an investment manager to receive 20% of the profits above the investors’ preferred return. This can translate into sizable income for an investment manager. How this additional income is taxed is the focus of this article along with the implications on a divorce proceeding.
What is the debate in the marketplace?
Over the years there has been much debate whether carried interest should be treated as ordinary income or as a long term capital gain for tax purposes. Historically carried interest has been treated as a long term capital gain. Treating the income as a capital gain results in a lower tax liability (23.8 percent tax rate) to the taxpayer who receives the K-1 from the partnership that holds the investment property. This tax rate is much lower compared to its ordinary income sister that would tax the income at a 39.6 percent tax rate. A difference of 15.8 percent in terms of the tax rate is meaningful to an investment manager, especially when significant monies could be exposed to taxes.
“Critics argue that these wealthy financiers should be paying more. The preferential tax treatment gives the wealthy an unfair advantage and deepens the divide between the rich and poor, they say. At stake is potentially billions of dollars. Congress’s Joint Committee on Taxation has estimated that changing the treatment of carried interest could raise about $16 billion over the next decade. Academics who have studied the issue say the figure could be much higher, $180 billion.” The Washington Post, November 7, 2017
How did the 2018 tax reform act impact how carried interest is taxed?
The 2018 Tax Reform Act instituted a minimum three (3) year holding period to allow carried interest generated from partnership interests, owned by individuals not corporations, to qualify for capital gains tax treatment (i.e. to be taxed at a lower tax rate). Said differently, if an investment manager receives carried interest where the investment is held for less than 3 years the income generated will be treated as ordinary income for tax purposes not long term capital gains. This change in the tax law is a major change as it translates into a lot of tax dollars that will now be collected by the government if an investment manager “flips” an investment in a short period of time. Hedge fund managers are known for making shorter term investments as opposed to private equity firms that usually hold investments for a longer period of time. Given there is a lot of money involved in hedge funds this change in the law will influence how they invest and when they sell to maximize their returns.
When this new ruling came out investment managers uncovered a tax loop hole. The ruling focused on how to tax partnership interests in partnerships, not equity interests in S Corporations. In other words, at the time of the ruling, the type of entity structure you used to hold your investments made a big difference as to whether the income would be taxed as capital gains or ordinary income.
Since it was publicly announced that investment managers were considering shifting their investments from partnerships to S corporations the government closed this tax loophole. The new ruling now specifically states S Corporations will have the same minimum three (3) year holding period as partnerships. In other words, taxpayers will not be able to circumvent the 3 year holding period using an S Corporation as a corporate exemption to avoid the ordinary income tax rates. The new carried interest rules take effect for tax years beginning after December 31, 2017.
How does carried interest impact a divorce?
From a tax perspective, the profits an investment manager receives from an alternative investment fall within a specific tax year (e.g. January 1, 2018 through December 31, 2018). In other words, it doesn’t matter when the profits were received during the tax year. Come tax time the 3 year holding period will be measured based on when the investment was made and when it was sold. This measurement period will determine whether the sale of that investment should be treated as ordinary income or capital gains.
In context to a divorce the measurement period and settlement date are critically important to keep in sync. Why? To maximize a divorcing party’s wealth many questions need to be diligently addressed such as:
- Which spouse will own the equity interests after the settlement date?
- Is it possible for the divorce transaction to create a new start date for the measurement period? In other words, if Spouse 1 buys the equity interests from Spouse 2 does the 3 year holding period start all over again?
- If the spouses cannot agree on the terms of how the income needs to be split is it possible for the partner to pay an ordinary income tax rate yet compensate the other spouse based on a capital gains tax rate to close their financial differences?
- What happens if the investment does not have the money to payout the carried interest yet the divorce decree requires a payout? Should the non-equity spouse have the right to force the distribution of profits to generate the carried interest so the non-equity spouse will receive the agreed upon compensation?
- Shouldn’t the cost basis of these investments be incorporated into the divorce decree to ensure the appropriate liability is being recorded on the marital estate for asset allocation purposes?
- When an investment is sold should it be treated on a FIFO basis for purposes of the divorce decree? What are the risks to each party? How should this be designed?
- What happens if the liability recorded does not follow the planned investment strategy and a higher or lower tax liability is the outcome? In other words the future liability will result in a different cash outlay than expected. How should this be addressed after the divorce is settled? Does this mean they have to go back to court?
- Could a divorce decree make the non-equity spouse liable to pay for future tax liabilities as a means of offsetting other agreed upon compensation?
- What happens if an investment manager already transferred the investment from a partnership into an S Corporation? How does this impact a divorce decree?
Carried interest has a number of variables that can prove quite costly to one or both divorcing parties. The types of questions that are raised is essential to ensure a divorcing party protects and maximizes their wealth through a divorce transaction.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
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About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
- preserve the value of their business or marital estate
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- build balanced financial solutions grounded in evidence
- find ways to make our client, and at times both parties, money through the process
- design their divorce to work for them and their family’s life
- provide mental clarity to make decisions
- reduce the total process time from start to close
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As we reach an agreed upon settlement structure, we help our clients identify a fitting attorney who can leverage the financial solution to draft and record the requisite legal documents. Where outcomes are at risk from a traditional process, we function as expert financial negotiators or financial mediators to turn around the situation and achieve our client’s desired outcomes.
Learn more about us at divorceoutcomes.com or review our blogs to gain a clearer understanding about our approach and how we maximize the financial outcomes for our clients.
Disclaimer
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.