Gilbert and Sullivan’s Mikado tells the story of Ko-Ko, a tailor and guardian of a beautiful young woman named Yum-Yum, who also is Ko-Ko's fiancée. Ko-Ko was sentenced to death for flirting but avoided his sentence by getting himself named Lord High Executioner.

Since Ko-Ko is first in line for execution, no executions occur, gaining the notice of the Mikado, who decrees there must be an execution within one month. After Nanki-Poo threatens to kill himself because he cannot have Yum-Yum, Ko-Ko suggests that he execute Nanki-Poo instead. Nanki-Poo agrees to the plan provided he can spend his final month married to Yum-Yum.

The plan falls apart when Yum-Yum learns that upon Nanki-Poo's execution, she would be buried alive with his corpse – a no-go for her. So, instead, Ko-Ko fakes Nanki-Poo's execution record and allows him and Yum-Yum to run off together to get married.

The Mikado arrives, and all seems well until he sees his son, Nanki-Poo's, name on the executioner's records. And to make things worse, Ko-Ko learns that Nanki-Poo was supposed to marry Katisha. But of course, Nanki-Poo can't do so now that he is married to Yum-Yum.

But this being Gilbert and Sullivan, all ends well. Ko-Ko admits that Nanki-Poo is alive (but married to Yum-Yum). And Katisha agrees to accept Ko-Ko, instead of Nanki-Poo, as her husband.

The Mikado’s plot has enough twists and turns to give the viewer whiplash. But Congress’ position on tax on carried interest similarly has left observers guessing.

Just over a week ago, in Changes to Tax on Carried Interest Would Lead to Conflicts of Interest, I wrote about a proposal in Congress to modify the tax laws relating to carried interests. However, now like Ko-Ko, carried interests may have received a reprieve. This article discusses where tax on carried interests stands under the bill passed by the Senate and how carried interests should be treated under tax law.

What’s the Current Law?

One way real estate and other fund managers make money from putting together investments is a “carried interest.” To incentivize managers to manage the investment well, they receive a percentage of the gain when the real estate is sold.

The manager doesn’t receive its payment unless the investment is successful. So, there’s an incentive for the manager to stay with the fund to a successful conclusion. After all, the manager often gets paid only after the investors get all their money back plus a guaranteed "preferred" return similar to interest.

Because a manager may never receive a dime from its carried interest, it has no value at the beginning of the investment. Therefore, it's speculative whether a fund manager will ever benefit from its carried interests.

The current law is based on the premise that a carried interest has no value when the fund manager receives it. The value of a carried interest is speculative – it could have a value or not depending upon the company's future performance. Therefore, the manager's carried interest is given a tax basis of zero. Therefore, any amount the manager receives later on account of the carried interest has received capital gain treatment.

Tax law distinguishes capital gains based on how long the investor owned the property. If the investor owned the property for more than one year, it is a "long-term capital gain." Gains on property held for less time are called "short-term capital gains."

Short-term capital gains are taxed at the same rates as regular income. But long-term capital gains are taxed at lower tax rates. Taxing long-term capital gains at a lower rate incentivizes people to save money and invest.

Until 2017, gains on carried interests were treated the same as other capital gains. However, the Tax Cuts and Jobs Act (“TCJA”) changed this. Now, a real estate or another fund manager must hold the carried interest for three years before it's eligible for long-term capital gain treatment. But the fund investors receive long-term capital gains treatment for investments held for just one year. If a real estate or other investment is held for less than three years (for a carried interest) or one year (for investors), the gain is a short-term capital gain taxed at ordinary income rates

What was Proposed?

Carried interests are frequently targeted for tax reform. For example, the Carried Interest Fairness Act of 2021 would have eliminated long-term capital gain treatment for carried interests.

Similar text was slipped in at the end of the Get the Lead Out Act of 2021, which would have addressed lead pipes in residences. Carried interest was a target in the Stop Wall Street Looting Act of 2021, which was proposed to pass liability from investment firms into private equity and other firms acquiring them. The Small Business Tax Relief Act, proposed in 2022 to lower corporate tax for small businesses, included a provision relating to carried interests. These bills would have eliminated long-term capital gains treatment for carried interests – but none of them progressed far.

However, the Inflation Reduction Act in the Senate initially included a provision that would have increased the holding period for long-term capital gains treatment for carried interests to five years. However, a last-minute agreement removed the carried interest provision from the Senate bill. So, at least for now, the tax treatment of carried interests won't change.

The Carried Interest “Loophole”

However, tax on carried interests is likely to come up again. Treating carried interests as long-term capital gains is viewed by many as a tax "loophole" that lines the pockets of already rich private equity and hedge fund managers. The term "loophole" implies that long-term capital gains treatment of carried interests is a manufactured tax benefit conjured by creative tax attorneys and accountants.

The truth is that tax treatment on carried interests has long been established under tax law. And just five years ago, when adopting TCJA, Congress debated the same issue when it increased the hold period for capital gains treatment of carried interests from one year to three years.

People may disagree whether the current tax treatment of carried interests is desirable or the law should be changed. But regardless of one's belief regarding what the law should be, there is no ambiguity – and no wealthy fund managers manipulating their way around the law. Rather, fund managers are following the law passed by Congress.

Comparing Carried Interests to Stock Awards

Those who want all carried interests taxed as ordinary income justify this approach by noting that carried interests are compensation for the manager's services. Under this analysis, carried interests are similar to corporate stock awards or grants given to employees.

As part of a compensation package, a corporation may give employees shares of the company's stock. This stock grant or stock award, as it’s called, usually will be conditioned on the employee remaining employed for a stated period. After that, the stock vests, and the employee can sell the stock subject to legal restrictions.

Stock grants can be considered employee compensation. But like carried interests, they also motivate employees to improve the company’s financial performance hoping the stock value will increase. Stock grants also encourage employee retention.

Employees have two options for taxing on stock awards: they can elect to be taxed on the value of the award when they receive it and have any increase in value upon sale taxed as a capital gain or pay no taxes until they sell the stock and have the sale price taxed as ordinary income.

Stock grants differ from carried interests in that the stock subject to the grant typically has a discernable value when the stock grant is given. Often, there is even a market for the stock, which makes the value easy to determine. Carried interests' value is speculative since they are based upon future events that may never occur.

Conclusion

All ended well in the Mikado. However, carried interests likely will again be put on the chopping block – with many hoping for a last-minute reprieve and others cheering on the executioner. But for now, carried interests will continue to be eligible for long-term capital gains treatment after a three-year hold period.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.