On Friday, July 31, the Internal Revenue Service (IRS) issued guidance in the form of proposed regulations on the “carried interest” rules under Section 1061 of the Internal Revenue Code (IRC). The “carried interest” rules were enacted as part of the Tax Cuts and Jobs Act (TCJA) and apply to tax years beginning after Dec. 31, 2017.
The “carried interest” rule of section 1061 recharacterizes certain net long-term capital gains with respect to applicable partnership interests (API) as short-term capital gains.
An API is any partnership interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business (ATB). The proposed regulations clarify the term “taxpayer” used in Section 1061. Taxpayer refers to both the person subject to the tax on the recharacterization and includes a passthrough taxpayer in the case where an API is held through another partnership (i.e., a tiered structure).
With respect to the performance of substantial services, the proposed regulations presume that services are substantial with respect to the partnership interest transferred in return for the services because it is assumed that the parties have economically equated the services performed with the potential value of the partnership interest transferred. The proposed regulations further provide that once a partnership is an API, it remains an API and never loses that character, unless one of the exceptions to the definition of an API applies. For example, if the API is transferred to another passthrough entity, a trust or an estate, the partnership interest remains an API.
An ATB is any activity conducted on a regular, continuous and substantial basis which, regardless whether the activity is conducted in one or more entities, consists in whole or in part of (A) raising or returning capital, and (B) either (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition), or (ii) developing specified assets. The proposed regulations establish an ATB Activity Test to determine if an activity is conducted on a regular, continuous and substantial basis. The ATB Activity Test is met if the total level of activity (conducted in one or more entities) meets the level of activity required to establish a trade or business for purposes of Section 162, which governs deductibility of business expenditures.
Specified assets are securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing.
Section 1061 provides exceptions to the definition of an API. The proposed regulations provide that those exceptions include partnership interests held directly or indirectly by a corporation (not including an S-corporation), capital interests (i.e., a return on an API holder’s invested capital in a partnership), partnership interests held by employees of entities that are not engaged in an ATB and APIs acquired by a bona fide purchaser who does not provide services, is unrelated to the service provider and acquired the interest for fair market value. Section 1061 also gives the U.S Department of the Treasury (the Treasury) the authority to provide an exception to Section 1061 for gain attributable to any assets not held for portfolio investment on behalf of third-party investors. However, the proposed regulations did not provide additional guidance on this matter at this time.
The amount recharacterized as short-term is equal to the difference in the taxpayer’s net long-term capital gain with respect to one or more APIs and the taxpayer’s net long-term capital gain with respect to the same APIs, applying a three-year holding period instead of a one year holding period. The proposed regulations provide that the recharacterization applies to capital gains allocated to the API holder by the partnership as well as capital gains recognized on the disposition of an API.
Taxpayers can own APIs directly or indirectly through passthrough entities (i.e., tiered structures). In a tiered structure of passthrough entities, API capital gains and losses retain their character as API capital gains and losses as they are allocated through the tiers.
The proposed regulations provide a taxpayer friendly provision that Section 1231 and 1256 gains, as well as qualified dividends taxed at the same rates as capital gains, are not gains subject to recharacterization. Capital gains also not subject to recharacterization are gains allocated to an API holder with respect to any capital interest an API holder also owns in the partnership and API Holder Transition Amounts. API Holder Transition Amounts are allocations to the API holder of long-term capital gain and loss recognized on the disposition of assets held by the partnership for more than three years as of Jan. 1, 2018, if the partnership has elected to treat these amounts as API Holder Transition Amounts.
Section 1061 accelerates the recognition of capital gain on a direct or indirect transfer to a related person that would not otherwise be a taxable event and recharacterizes certain long-term capital gain (gains with a three-year holding period or less) as short-term capital gain. The proposed regulations provide that the term transfer includes, but is not limited to, contributions, distributions, sales and exchanges and gifts. A related person for this purpose includes the taxpayer’s family members, the taxpayer’s colleagues (i.e., those who provide services in the ATB during certain time periods) and a passthrough entity to the extent that a member of the taxpayer’s family or colleague is an owner. Transfers to a partnership do not cause an accelerated gain because the proposed regulations require that, under the principles under Section 704(c), all unrealized API gains at the time of contribution must be allocated to the API holder contributing the interest when those gains are recognized by the partnership.
The Treasury and the IRS are aware that taxpayers may seek to circumvent the “carried interest” rules by waiving their rights to gains generated from the disposition of a partnership’s capital assets held for three years or less and substituting other capital gains held more than three years or use other similar arrangements to avoid recharacterization. The preamble to the proposed regulations states that taxpayers should be aware that these types of arrangements may not be respected by the IRS.
The proposed regulations provide that the one-year and three-year holding periods apply to installment sale gains, regardless of whether the installment sale occurred before the effective date of Section 1061. Accordingly, if an API was sold before Jan. 1, 2018, and had a two-year holding period at the time of the sale, gain is recognized on or after Jan. 1, 2018, and is subject to Section 1061, even though the disposition occurred before the effective date of Section 1061.
Finally, the proposed regulations provide rules for reporting information to API holders to properly report the long-term capital gain recharacterized as short-term as well as information required to be provided to upper tier partnerships in the case when an API is issued to another partnership.
For more information, reach out to us at firstname.lastname@example.org.