California Franchise Tax Board Provides Guidance On Carried Interest

On December 1, 2020, the California Franchise Tax Board (FTB) Chief Counsel released commentary in the December edition of FTB Tax News addressing Carried Interest. The commentary is in response to the proposed regulations released by the U.S. Department of the Treasury and the IRS on July 31, 2020 under Internal Revenue Code (IRC) Section 1061 on carried interests (i.e., profits interest of a partner in a partnership).

A carried interest is an interest in the profits of a partnership that the general partners receive as compensation irrespective of their capital investment in the partnership. From a federal income tax perspective, the proposed regulations address a highly debated issue on the treatment of carried interests, i.e., whether income of such interests are taxed as capital gains or ordinary income in light of the  new holding period requirements on carried interest included in the Tax Cuts and Jobs Act. Unless the income is recharacterized under Section 1061, the character of the income to the partner is the same as if the income were realized directly by the partnership. As a result, a partner may realize capital gains instead of ordinary income if the partnership generates capital gains income.

While California does not have preferential tax rates for capital gains, the state generally conforms to the federal partnership provisions of the IRC as they existed on January 1, 2015. As a result, California does not conform to Section 1061 or the proposed regulations under this code section. For California income tax purposes, a carried interest is treated as a partner’s distributive share of partnership income. Income and profits allocable to a carried interest holder will retain the partnership-level character.

The Chief Counsel’s guidance discusses the difference in the sourcing of income for residents compared to nonresidents that are partners in a partnership doing business in California. A nonresident’s distributive share of an apportioning partnership’s business income attributable to the nonresident’s carried interest is sourced to California under the state’s market-based sourcing rules as income from a trade or business (and not as compensation for services).

Per the Chief Counsel’s discussion, “like federal law, California treats a carried interest as a partner's distributive share. Such distributive share is sourced to California according to CCR [California Code of Regulations] Section 17951-4 for California personal income tax purposes, provided that it is from a trade or business and R&TC Section 1795-5 does not otherwise apply.” The FTB is applying this position to open years.