By Thomas J. Gallagher, JD
The Tax Cuts and Jobs Act (TCJA) added new rules for the taxation of so-called “carried interests” in Internal Revenue Code (IRC) Section 1061, effective for taxable years beginning after Dec. 31, 2017. Section 1061 provides that allocations of capital gain income attributable to certain carried interests qualify for the long-term capital gain rate of 20% only where the underlying asset was held for more than three years at the time of sale or disposition of the asset. On July 31, 2020, the IRS issued proposed regulations that would provide guidance on the implementation of the statutory rules. The proposals are likely to have an impact on income tax planning for the receipt of carried interests, transfers of interests, and tax reporting.
The classic carried interest is a right to receive a share of the profits of a partnership in which the holder does not have a right to receive money or other property on the immediate liquidation of the partnership at its current fair market value. If X is issued an interest in an LLC with a right to share in the distributions of the LLC that is subordinated to the return of 100% of the existing net capital value (fair market value, not book value, or the amount of prior capital contributions) of the LLC to its members, assuming that the LLC liquidated in accordance with the terms of its agreement, X is viewed as having received a carried interest. This is distinguished from a case where X received a right to share in the proceeds of the liquidation of the LLC, assuming a liquidation at fair market value immediately following the admission of X. In that case, X is treated as having received a capital interest. In the typical case, X would receive a capital interest only where X contributed equivalent capital value or treated the grant of the capital interest as taxable compensation.
Before Section 1061, the IRS had issued two Revenue Procedures establishing ground rules of the nontaxable issuance of carried interests that made it relatively easy for members receiving a carried interest for services to achieve long-term capital gain treatment. The proposed regulations generally follow the framework created by earlier IRS rules. Nevertheless, the TCJA rules recharacterize certain long-term capital gain to short-term capital gain in the case of so-called “applicable partnership interests” (API). The amount of taxable gain from an API is treated as short-term capital gain (taxable at ordinary income rates) equals the amount of the taxpayer's net long-term capital gain from all the APIs for the taxable year in excess of the amount of the long-term gain calculated based on a three-year holding period, rather than one year. Generally, a capital interest in a partnership giving the taxpayer a right to share in partnership capital commensurate with the amount of capital contributed is not an API.
The following are important takeaways within the IRS’s proposed regulations:
- An API is a partnership interest transferred in connection with the performance of services in any applicable trade or business (ATB). Once an API, almost always an API. Further, the new rules apply to gains recognized after Dec. 31, 2017, so that they apply to APIs issued prior to that date. There are also rules to determine whether the service partner’s share of a long-term gain incurred by a lower-tier passthrough entity is subject to the Section 1061 extended holding period.
- An ATB is any activity conducted on a regular, consistent, and substantial basis that consists, in whole or in part, of raising or returning capital and either investing in or developing securities, commodities, real estate, cash or cash equivalents, options, or derivatives involving these assets. The classic venture fund would ordinarily be an ATB. The proposed regulations presume that the transferee of a carried interest rendered substantial services.
- Transfers of any portion of an API by a service partner generally trigger an acceleration and recognition of the unrealized short-term capital gain where the transferee is a related person, even if the transfer is otherwise nontaxable (e.g., a gift).
- Although allocations of gain attributable to a capital interest are exempt from the three-year rule, the definition of capital interest is narrowed by the proposed regulations. Where a service partner holds both an API and a capital interest, holding the API (directly or indirectly) could cause income or gain from the capital interest to be subject to the three-year rule unless the new rules are met.
There are important exceptions. C corporations (but not S corporations) are exempt. Gains from IRC Section 1231 property (i.e., generally depreciable property or real property used in a trade or business, and held for more than one year) are not subject to the rules.
The proposed regulations contain a number of reporting requirements not likely to be found in existing partnership and LLC agreements, such as providing information to upper-tier entities. A failure to supply the information could deprive the API holder of the benefits and exceptions to Section 1061.
The IRS’s proposed regulations generally are for taxable years beginning after their publication in final form, although taxpayers are permitted to rely on proposed regulations prior to that date as long as they follow them in their entirety and in a consistent manner.
Thomas J. Gallagher, JD, is a member of Cozen O’Connor in Philadelphia. He can be reached at email@example.com.
Sign up for weekly professional and technical updates in PICPA's blogs, podcasts, and discussion board topics by completing this form.