The IRS released proposed regulations on July 31, 2020 that would implement the three-year holding period requirement for holders of carried interests in a partnership. The three-year holding period for carried interests was introduced in Section 1061 of the Internal Revenue Code (IRC), as part of the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA). President Trump’s landmark tax law altered the timeline for when gains recognized in regards to a carried interest (i.e., an Applicable Partnership Interest, or API) could qualify for long-term capital gains treatment.
Beginning in 2018, capital gains with respect to an API that do not satisfy a three-year holding period and that are allocated to an API holder must be recharacterized by the API holder from long-term to short-term. This holding period requirement also extends to the external sale of a partner’s API itself.
The proposed regulations will become binding once they are finalized and published in the federal register, but taxpayers generally can rely on them prior to such time if they so choose. Understanding what has been proposed can help us understand how the IRS views the new carried interest rules, and can give partnerships an idea of what to expect when the final regulations are released.
Capital Interest Exception & Other Exceptions
Notwithstanding the general three-year holding period requirement for holders of an API, the tax law provides an exception for capital gains recognized with respect to a “capital interest.” Moreover, the law provides that this exception applies to a partner’s claim against total partnership capital that is commensurate with the partner’s contributed capital, or that is commensurate with the value of the partner’s capital received as taxable compensation. The Proposed Regulations would impose strict guidelines for what types of partnership allocations made pursuant to such an interest qualify under these criteria.
Moreover, an allocation to an API holder will satisfy the capital interest exception only if:
- (1)All partnership allocations are made relative to the API holder’s IRC Section 704(b) capital account balance;
- (2)The right to property distributions (i.e., claim against partnership capital) during the partnership’s operations is the same as the right to property distributions at the time of liquidation;
- (3)The terms of the allocations to the API holder and to unrelated non-service partners are identified in the partnership agreement as well as the partnership’s books and records, where the allocations are clearly separate and apart from other allocations; and
- (4)The partnership makes allocations to the API holder and to unrelated non-service partners under the same terms, priority, type, level of risk, and rate of return.
Hence, the capital interest exception can only apply when the partnership has both API holders and unrelated non-service partners. Furthermore, unrelated non-service partners exist for this purpose only when such unrelated partners aggregately hold 5% of more of total partnership capital at the time the allocation is made.
This narrow definition for a capital interest raises interesting questions, notably:
- In a partnership that allows partners to elect whether or not to participate in investment deals, how will specific deal allocations be treated related to capital interests?
- How will different “investor-specific” arrangements impact the application of the capital interest exception (i.e., management fee waivers, the right to receive tax distributions, and investor side letter agreements)?
- Purchasing an API is treated differently than contributing capital in exchange for an API interest.
- Section 1061 recharacterization only applies to capital gains.
- Distributing property in-kind does not erase the Section 1061 recharacterization.
- The Proposed Regulations did not definitively conclude on whether or not carried interest waivers would be respected.
The capital interest exception does not apply to invested capital funded by loans supplied by or guaranteed by another partner, the partnership, or a related party except when the load is paid.
While allocations made with respect to a capital interest require a more nuanced analysis, the Proposed Regulations provide that certain partnership allocations are never subject to the general three-year holding period requirement. Notably, qualified dividend income and income that qualifies for long-term capital gain treatment such as IRC Section 1231 gains and IRC Section 1256 gains are all exempt from the general three-year holding period requirement.
Application of Lookthrough Rules on Sale of an API
The Proposed Regulations would apply a “Lookthrough Rule” that could result in recharacterization of an API holder’s long-term capital gain to short-term capital gain when the API holder sells the API itself, even if the API was held for a period greater than three years. The intent of the Lookthrough Rule is to prevent an API holder from avoiding an allocation from the partnership of items that would be subject to recharacterization by pre-emptively selling the API before the allocations are made.
The Lookthrough Rule applies when the fair market value of the assets of the underlying Applicable Partnership meet a “Substantially All Test.” The Substantially All Test is met when 80% or more of the value of the assets of the Applicable Partnership have a less than three-year holding period.
This Lookthrough Rule can be applied to tiered partnership structures, as long as the underlying Applicable Partnerships meet the Substantially All Test.
Transfers of an API to Related Persons
Under the Proposed Regulations, transferring an API to a related person will accelerate the gain recognition on any built-in appreciation related to partnership assets with a less than three-year holding period. Even for transfers that would otherwise be nontaxable (like gifts less than the annual $15,000 exclusion), IRC Section 1061 recharacterization would apply and the transferring partner would recognize short-term capital gain.
The regulations define “related persons” more narrowly than other sections in the IRC. The definition only includes members of the partner’s IRC Section 318(a)(1) family, certain family partnerships, and a person that performed services for the business any time in the last three calendar years (colleague).
The Proposed Regulations would outline some other notable rules related to IRC Section 1061, including:
An unrelated, non-service provider can purchase an API interest and avoid Section 1061 recharacterization on subsequent capital gain allocations. However, if that same purchaser contributes capital in exchange for their API, Section 1061 would apply.
Capital losses with a three-year-or-less holding period will not be recharacterized as short-term losses. This treatment may produce an unfair result when losses are netted with gains at the partner level.
If the asset received is subsequently sold within the three-year holding period, the gain will be recharacterized to short-term.
However, the preamble did mention that the IRS could challenge such waivers on audit based on partnership anti-abuse and disguised sale rules.
The Treasury Department is accepting public comments on these proposed rules and will use that information to inform the final regulations. If you have further questions about the carried interest rules or want to know how the Proposed Regulations may impact your business, please contact us for assistance.
Published on September 29, 2020