Chief Counsel Corner December 2020 Tax News

Carried interest

Jozel Brunett, Taxpayers' Rights Advocate.

Jozel Brunett
Chief Counsel

As many of you are probably aware, on August 14th 2020, Department of Treasury published proposed regulations under Section 1061 of the Internal Revenue Code (IRC) addressing carried interests. With the subject at the center of attention, questions came up as to the Franchise Tax Board's view on the sourcing of a carried interest for California personal income tax purposes.

A carried interest (sometimes referred to as an incentive allocation or a performance allocation) is an interest in a partnership's profits that the general partners of the partnership (i.e. private equity and hedge funds) receive as compensation irrespective of their capital investment in the partnership. There has been much debate over the federal income tax treatment of a carried interest (i.e. capital gain vs. ordinary income).

In general, a carried interest is taxed as a partner's distributive share for federal income tax purposes. [1] The character of the income in the hands of the general partner is the same character as if such income were realized directly by the partnership [2] unless it is recharacterized under IRC Section 1061. As a result, the general partner may realize capital gain instead of ordinary income if the partnership generates capital gain income.

California generally conforms to the federal partnership provisions of the IRC, as they existed on January 1, 2015, through California Revenue & Taxation Code (R&TC) Section 17851. As of now, California does not conform to IRC Section 1061 and the proposed regulations thereunder. Additionally, California does not have preferential tax rates for capital gains. For California income tax purposes, a carried interest is treated as a partner's distributive share. Income and profits allocable to a carried interest holder will retain the partnership-level character.

California imposes a tax on the income of a nonresident, including his distributive share of partnership income, to the extent it is derived from sources within this State. [3] With the exception of R&TC Section 17955 regarding investment partnerships, income from a partnership that carries on a trade or business is generally sourced under California Code of Regulations (CCR) Section 17951-4. A nonresident's carried interest (distributive share) from a partnership that does business wholly within California is sourced entirely to California. [4] The opposite applies to partnerships that are wholly outside of California. In addition, CCR Section 17951-4(d) makes reference to the UDITPA rules (Sections 25120-25139) for sourcing income of a partnership that does business within and outside of California (i.e. an apportioning partnership). A nonresident's distributive share of an apportioning partnership's business income attributable to his carried interest is sourced to California in accordance with the UDITPA rules. For example, if the apportioning partnership derives all of its revenue from sales of marketable securities, it will assign the receipts from the sales to its California sales factor numerator by applying CCR Section 25136-2(e) and use the result to compute its sales factor. The partnership will then use the sales factor to apportion its business income to California as required by R&TC Section 25128.7. The general partner owning the carried interest will be taxed on his distributive share of the partnership income apportioned to California per CCR Section 17951-4(d)(1). A nonresident's distributive share of a partnership's nonbusiness income attributable to his carried interest is sourced according to CCR Section 17951-4(d)(4).

In summary, like federal law, California treats a carried interest as a partner's distributive share. Such distributive share is sourced to California according to CCR Section 17951-4 for California personal income tax purposes, provided that it is from a trade or business and R&TC Section 17955 does not apply.

[1] The character of a payment to a partner from a partnership is governed by the partnership provisions of the IRC governing distributive shares, payments under Section 707(a), and guaranteed payments under Section 707(c). A carried interest entitles its holder to partnership income allocation and thus is treated as a partner's distributive share.

[2] IRC Section 702(b).

[3] R&TC Section 17041(b), 17951(a), and 17953. For purposes of R&TC Section 17041, guaranteed payments from a partnership is included in the computation of a nonresident's gross income from sources within this state in the same manner as if the payments were a distributive share of the partnership. R&TC Section 17854.

[4] CCR Section 17951-4(a)