Carried interest for Section 1202 purposes is a hazy chasm for tax professionals to cross because there is a mixed bag of authoritative literature. A tax position is considered as having a reasonable basis if (i) is/was substantial authority for the tax position, (ii) the position was disclosed with Form 8275 under Section 6662(d)(2)(B)(ii)(I), and (iii) there is a reasonable basis for the opinion under Section 6662(d)(2)(B)(ii)(II).
According to a case study done by the AICPA’s Tax Advisor, there is a reasonable basis for carried interest to qualifying for the section 1202 tax exclusion. Because Section 1202 can be rolled into another investment under Section 1045 the tax law links the two when it comes to authoritative literature. Under Section 1045 there is not substantial authority because the literature is inconsistent in its meaning of what interest is transferable (capital interest or profits interest) and under Section 1202 it is ambiguous as to what the partnership interest amount is at the time the stock was acquired. Due to these inconsistencies, under Regs. Section 1.6662-3(b(3) there is a reasonable basis for carried interest to be excluded from capital gains under Section 1202 because a profits interest, aka carried interest, is reasonable under more than one authority.
Although there is a reasonable basis there is no substantial authority; therefore, it would be best practice to disclose the Section 1202 election for carried interest. Also, the gain would only qualify as long as the taxpayer or limited partner holds the stock for five years unless section 1045 is elected. Most recently Representative Mark Pocan and Senator Elizabeth Warren introduced the “Stop Wall Street Looting Act“, which included under Section 710 of the draft legislation a change to Section 1202’s gain exclusion. The draft legislation stated that the gain exclusion would no longer apply to an “investment services partnership interest” (i.e. carried interest). The proposed legislation has not passed and has not been included in the tax reform proposed by President-elect Joe Biden.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.