Similar to the movie, the enactment of the Tax Cuts and Jobs Act (TCJA) featured strong personalities in conflict, had real money at stake, left a wake of destruction, and, in the end, left everyone wondering whether they should be happy or unsettled with the outcome. This article breaks down the TCJA’s key changes to partnership taxation that impact the private equity industry, namely, the introduction of the “qualified business income” (QBI) deduction (the Good), the change to the taxation of carried interest (the (not so) Bad) and the re-imposition of tax on non-US partners on their sale of an interest in a partnership that has “effectively connected income” (ECI), along with the introduction of a new withholding regime to enforce it (the Ugly). In addition to explaining these changes (including some subsequent developments since the TCJA’s enactment), we discuss their impact on the private equity industry and consider whether private equity firms should be cheering or booing now that some of the dust has settled.

The (Not So) Bad – Changes to the Taxation of Carried Interest

Overview of the Taxation of Carried Interest. Carried interest is an interest in the future profits of a partnership that is granted to a partner in exchange for services. It represents an entitlement to the allocations and distributions of a partnership’s income based on the terms of the partnership agreement. Carried interest does not inherently generate long-term capital gain treatment. Rather, the tax treatment depends entirely on the type of investments and income earned by the partnership. For most private equity funds that hold investments for over a year, income realized by the fund from dispositions represents long-term capital gain, entitling individual partners to favorable capital gains rates. Prior to the TCJA, this entitlement extended to carry recipients.

A Change Long in the Making. The taxation of carried interest has been a hot political issue for decades and became a part of everyday conversations as a result of the 2012 presidential campaign of Mitt Romney. One of President Trump’s campaign themes also focused on amending the taxation of carried interest. Many have called for closing the carried interest “loophole,” arguing that carried interest received by investment managers represents compensation (subject to ordinary income) rather than an investment interest in a partnership (subject to taxation based on the income of the partnership itself). Although prior proposals generally aimed at ending the “loophole” by taxing all or a portion of the income allocated to the carried interest recipient as ordinary income regardless of the character of the partnership’s income, the TCJA’s change to the treatment of carried interest was ultimately quite novel and significantly more limited.

TCJA Regime. The TCJA (in newly enacted Section 1061 of the Internal Revenue Code (Code)) requires a three-year holding period for capital gains income allocated to a carried interest recipient to qualify for the preferential tax rates associated with long-term capital gains. The rule applies to partnership interests transferred in connection with the performance of substantial services to an “applicable trade or business.” The regime does not apply to income recognized with respect to any capital invested by a carry recipient. The three-year holding period rule generally applies at the partnership’s investment level, requiring the partnership to satisfy the three-year holding period for any capital gain recognized by the partnership and allocated to the carried interest recipient in order for the recipient to qualify for the preferential rates. While the change from one year to three years is significant and will likely impact some of the carry earned by most sponsors of private equity funds and may impact most of the carry earned by other sponsors (e.g., credit funds with shorter term holding periods), carried interest will continue to enjoy long-term capital gains to a large extent. In addition, there are some important exemptions that may allow sponsors to mitigate the impacts of the new regime.

The regime as drafted only applies to capital gains, so certain dividend income (“qualified dividend income” (QDI)) that also currently qualifies for the same preferential rates as long-term capital gains should still be eligible for the preferential rates, irrespective of the partnership’s holding period at the time of the dividend. This makes dividends and leverage recapitalizations much more attractive options for carry recipients. The new regime also does not appear to cover gains from the sale of property used in a business, and it is unclear how the rule will apply to certain other types of income (e.g., the treatment of capital gains dividends from real estate investment trusts (REITs)). Other strategies available include making distributions in kind to the carry recipient, if possible, and structuring follow-ons and dispositions of follow-ons in a manner that maximizes qualifying income. Private equity sponsors will need to manage their fiduciary obligations to their investors with their own interests.

Additionally, the nature of a typical private equity fund’s investment cycle (e.g., investments generally made upfront, held for a number of years and disposed of over time), private equity economics (which typically include a preferred return) and the detailed mechanics of how taxable income is allocated to partners all have the potential to mitigate the applicability of the new regime.

Many private equity firms have already added or are considering adding mechanics in their economic arrangements that allow them to waive carry if the recipients of carried interest would be allocated short-term capital gain and to elect to take such waived allocation from another investment. However, it is currently unclear how such waivers need to be implemented in order to be effective and may likely require that the waived allocation only be taken to the extent of any appreciation from assets after the waiver, so the carried interest recipients are taking economic risk that such appreciation does not arise.

Overall, while the TCJA’s new carried interest regime is undoubtedly a negative development for private equity personnel, it is widely viewed as not significantly impacting the industry. On a positive note, now that the carried interest “loophole” has been addressed, the TCJA may have actually removed some uncertainty that has been looming over the industry for many years.

The Good – Qualified Business Income Deduction

One of the major themes of the Republican Party’s tax reform plan from its inception has been tax cuts for small businesses, many of which operate in partnership form. The TCJA enacted Section 199A of the Code (currently only effective through 2025), which provides for a 20% deduction on QBI and, when combined with the slightly lower top marginal individual tax rate of 37%, has brought the effective top marginal tax rate on such income down to 29.6% (from 39.6% prior to the TCJA). The IRS recently issued proposed regulations on the QBI deduction. (More information is available at

The deduction is only available to noncorporate taxpayers that are owners of sole proprietorships and other fiscally transparent tax entities including partnerships and S-corporations. The deduction applies only to ordinary business income from a US business. The deduction is capped at 50% of W-2 wages paid by the business or, if higher, 25% of the W-2 wages plus 2.5% of the cost of tangible depreciable property used in the business. The deduction is not available to income earned from a “specified trade or business,” which includes income from a manager of a private equity fund. Management fees earned by a fund manager will therefore generally not qualify for the QDI deduction.1 The W-2 wage cap and specified trade or business exclusion do not apply to taxpayers below certain inflation-adjusted income thresholds (for 2018, $315,000 for joint filers and $157,000 for individual filers, and fully phasing in at $415,000 and $207,500, respectively).

Although the QBI deduction will not apply to management company profits, it will nevertheless be relevant to the private equity industry for portfolio companies that are in pass-through form and meet the criteria. First, investment professionals will get the benefit of this deduction with respect to their ordinary income allocations from such investments in respect of their capital and carried interest. Second, and perhaps more importantly, the QBI deduction may present a planning opportunity to structure compensation arrangements for senior management personnel of such investments in a tax-efficient manner by granting them a profits interest in the business. Unfortunately, the proposed regulations have limited the ability to convert bonus and other compensation plans to equity arrangements to take advantage of the QBI deduction. Additionally, the new QBI regime will require more extensive tax accounting and may complicate discussions with lenders on the appropriate amount that may be distributed out of the business as a tax distribution.

The Ugly – Re-introduction of ECI Tax on the Sale of a Partnership Interest and a New Withholding Regime

Tax Court Decision Overturned. Less than a year ago, non-US taxpayers, and by extension the private equity industry, were cheering when the US Tax Court rejected the IRS’s longstanding position that a non-US partner’s gain on the sale of an interest in a partnership with ECI is subject to US federal income tax.2 The ruling set into motion a frenzy of discussions on how private equity funds could adjust their go-forward blocker structures and restructure their existing blocker structures. In our Fall 2017 Private Equity Report,3 we discussed this case and suggested caution given the likelihood of the case being overturned either on appeal or through regulation or codification. Caution was the right approach.

New Withholding Regime. The TCJA not only codified the IRS’s original position, but it also introduced a new withholding regime on the sale of the partnership interest. Fortunately, some of the sting has (at least temporarily) been relieved in the form of recently announced interim Treasury and IRS guidance that taxpayers may rely on until regulations are issued.4

The new withholding regime requires a 10% withholding on the amount realized on the sale by a non-US seller of a partnership interest if any portion of the gain would be treated as ECI. Initially, this is an obligation of the buyer; however, the TCJA also imposed a secondary withholding obligation on the partnership itself if the buyer does not properly withhold. The recent guidance suspended the partnership obligation for now, but Treasury has indicated that this relief may be temporary.

Exceptions to the Withholding Regime. The Treasury and IRS guidance provides a number of important, but limited, exceptions to the withholding regime summarized below. More fulsome discussion of the guidance is provided in our client update.5

First, the guidance confirms that US sellers can avoid withholding by providing a Form W-9. However, it does not appear as though a non-US partnership with US partners can pass through their Form W-9s to avoid withholding on their share of the proceeds.

The guidance also provides a 25% de minimis exception. No withholding is required if either (1) the seller can certify that its share of ECI represented less than 25% of its share of partnership income in each of the three prior taxable years or (2) the partnership can certify that if it sold all its assets, less than 25% of the gains would be ECI. However, general partners may be hesitant in providing such certifications as the first option requires the seller to have been a partner during the three prior taxable years and the latter option opens up the partnership and the individual signing the certification to potential liability.

If withholding applies, it is imposed on 10% of the amount realized on the sale of the partnership interest. The amount realized generally includes any cash and other proceeds plus the seller’s share of partnership liabilities (which the buyer and seller generally do not know at the time of a transfer of a private equity fund interest). Fortunately, the recent Treasury guidance also provides some clarity.

Similar to the certifications above, either (1) the seller can certify its share of partnership liabilities based on its most recent Schedule K-1 or (2) the partnership can certify the seller’s share of partnership liabilities. The partner certification is likely only available for transfers that occur in the summer and fall months because a Schedule K-1 is only valid for this purpose for ten months from the end of the prior tax year.

If the buyer is not provided with a certification of an exemption from withholding or a certification as to the amount of liabilities to be taken into account, the buyer must withhold all the cash proceeds.

Even though private equity funds themselves are not currently subject to these transfer rules (other than on redemptions), private equity funds must become familiar with these rules and develop their practice for handling certification and information requests from investors.

End Notes

1 Section 199A, through the incorporation of Section 1202(e)(3) of the Code, also included a catch-all exclusion for “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” The proposed Treasury regulations fortunately narrowed the scope of this exclusion. See Prop. Treas. Reg. § 1.199A-5(b)(2)(xiv).

2 See Grecian Magnesite Mining, Industrial & Shipping Co., S.A. v. Commissioner, 149 T.C. No. 3 (July 13, 2017), available at

3 The Private Equity Report, Fall 2017, Vol. 17, No.2.

4 IRS Notice 2018-29.

5 New Guidance on Withholding on Sales of Partnership Interests, April 4, 2018.