IRS Updates Tax Reporting Requirements for Carried Interest by Angie Adames, CPA
Posted on April 05, 2022
by
Angie Adames
At the end of 2021, the IRS issued new guidance for certain passthrough entities and other taxpayers to use for purposes of reporting applicable partnership interests (API) held in connection with the performance of services, also referred to as “carried interest.” The guidance, provided in the form of frequently asked questions (FAQs), updates final regulations released in January 2020 and applies to tax returns filed after Dec. 31, 2021, for tax years beginning before Jan. 19, 2021.
Carried interest is the share of a partnership’s future profits that are paid to a general partner or fund manager as compensation for their performance of substantial services regardless of whether they contributed any capital to the entity. In this sense, carried interest, also referred to as “promoted interest”, can be viewed as deferred compensation or an additional fee paid to a partner based on the partnership’s overall performance.
Under Section 1061 of the Internal Revenue Code, introduced in 2018, capital gains allocable to carried interests and the underlying investment assets held for more than three years qualify for long-term capital gain treatment at a top rate of 20 percent (plus the 3.8 percent net investment income tax (NIIT). By contrast, gains from the sale of capital assets held for one to three years must be recharacterized as short-term capital gains that are taxed at ordinary income rates, which top at 37 percent (plus the 3.8 percent NIIT).
The FAQs recently released by the IRS include sample worksheet A that passthrough entities, such as partnerships, trusts and estates, S corporations and passive foreign investment companies (PFICs), must attach to each API holder’s Schedule K-1, to calculate and report the entities’ API one-year distributive share amount and API three-year distributive share amount in accordance with the final regulations issued on Jan. 19. 2021. The API owner taxpayer calculates the amount that is treated as short-term capital gain and applies the final regulations using Worksheet B to determine the owner taxpayer’s recharacterization amount and attaches it to the owner taxpayer’s return.
Tax returns filed by passthrough entities and taxpayers after Dec. 31, 2021, for tax years beginning before Jan. 19, 2021, must disclose whether the reported information is determined under the proposed regulations or another method, and they must attach to their tax returns information similar to that required on Worksheets A and B. It is recommended that passthrough entities and their owners meet with their tax accountants and advisors to navigate the new compliance requirement.
About the Author: Angie Adames, CPA, is a director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where she provides tax and business consulting services to real estate companies, manufacturers and closely held entities. She can be reached at the firm’s Miami office at (305) 379-7000 or info@bpbcpa.com.
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