Potential impact of proposed Carried Interest Fairness Act of 2021

By Kindal Barnes and Mark Martinelli

Congress has drafted the Carried Interest Fairness Act of 2021, which treats partnership, profits interest received for personal service income as ordinary income.  

The ordinary character is achieved through modifications to the existing partnership rules and adding IRC Section 710, Special Rules for Partners Providing Investment Management Services to Partnerships.  

The term “investment services partnership interest” means any interest in an investment partnership acquired or held by any person in connection with the conduct of a trade or business primarily involved in the performance of any of providing investment services with respect to assets held by one or more investment partnerships.   

The definition of the specified trade or business appears to be broadly written with the intent of capturing all parties providing investment advice or management to investment partnerships.

All income earned from an investment services partnership interest is treated as ordinary income and the gain or loss on disposition of an investment services partnership interest is ordinary gain or loss.  The new code section attempts to prevent using strategic partnership interest transfers to escape the investment management partnership interest characterization.  Logically, the proposed bill does recognize that fund managers frequently invest their own capital into the investment partnerships and provides that within certain limitations, income earned on the capital interest retains its taxable income character, including long term capital gains.

Additional features in the proposed legislation include making §83(b) the default for profits interest granted in exchange for services.  In certain situations, this may force an income recognition upon the receipt of carried interest rights.  Also, Venture Capital managers are specifically impacted by removing the taxable gain deferral on IRC Code 1202, qualified small business stock.

If the bill as drafted become law, fund managers, attorneys, and tax advisors can expect to spend time in the coming years determining the best approach minimize the tax impact.  This may also reduce the frequency with which fund managers elect management fee deferral in favor of additional profits interest