By Tom Ochsenschlager, J.D., CPA
Section 1061 enacted with the Tax Cuts and Jobs Act (TCJA) generally requires that a taxpayer, other than a C corporation, must hold a “carried interest” in a partnership for three years to be treated as a long-term capital gain. On Jan. 7, the IRS issued final regulations in TD 9945 providing the details for implementing the three-year requirement. The final regulations are effective for tax years beginning on or after Jan. 19, 2021, but taxpayers have the option to apply them the effective date of the TCJA.
The three-year holding period applies regardless of whether the receipt of the carried interest is not subject to tax in accordance with Rev. Proc. 93-27. The guidance is effective when the regulations are made final, but taxpayers have the option to apply them to tax years beginning after Dec. 31, 2017, the effective date of the TCJA.
A carried interest is described as an interest in a partnership received by an “applicable trade or business” (ATB) in exchange for having provided “substantial services” for the partnership. Under Section 1061, a service is substantial if it consists of raising or returning capital, or investing in, disposing of, or developing specified assets. For example, such an interest is relatively common in real estate partnerships where an individual receives a partnership interest for having negotiated the terms and conditions for the purchase of, say, an apartment complex on behalf of the partnership. The proposed regulations provide a detailed definition of an ATB that generally comports with an entity that is engaged in providing substantial services as described above.
It is important to note that the three-year holding period continues to be applicable to any individual or entity, other than a C corporation, to whom the ATB transfers its interest in the partnership. The proposed regulations’ preamble clarifies that where the services are provided through a tiered structure, each passthrough entity in the tiered structure is subject to the three-year holding period requirement for long-term capital gain treatment. Transfers of a carried interest to a related or unrelated entity are subject to revaluations at the date of the transfer. If the transfer is a gift to a related person within the three-year holding period, it is subject to tax at the donor level – an exception to the general rule that gifts are not taxable. The three-year holding period cannot be avoided by utilizing an installment sale of the carried interest. The holding period is based on the date of the sale regardless of when the cash is received.
The three-year holding period requirement not only applies to a disposition of the partnership interest by the ATB, it also applies to that partner’s share of the partnership’s long-term capital gain other than the partnership’s Sections 1231 and 1256 gains (and losses), qualified dividends under Section 1(h)(11) and mixed straddle rules described in Section 1092(b). The proposed regulations provide an exception referred to as “partnership transition amounts” whereby the partnership can elect an exception for the disposition of assets that were held by the partnership for more than three years as of Jan. 1, 2018. The partnership can make this election for its taxable year beginning in 2020 or later but, once the election is made, it is applicable to all subsequent years.
The proposed regulations provide complex rules for a few exceptions whereby, in general, the three-year holding period does not apply to distributions from the partnership related to the amount of capital that was contributed to the partnership by the ATB and/or distributions that are subject to tax under Section 83. However, it does apply to the distributive share of gain from the sale of any asset held less than three years by the underlying partnership.
The proposed regulations explain that the entity receiving the substantial services must provide the carried interest taxpayer with information required to comply with Section 1061 and, similarly, the carried interest taxpayer must provide similar information for any recipient of its transfer of any portion of the carried interest.
The final regulations clarify several issues that had been raised with the proposed regulations:
- Where an ATB partner has a capital interest in the partnership that is in addition to the partner’s interest from providing services;
- Situations where the ATB partner makes a loan to the partnership and the loan is repaid by another partner;
- The rules applicable where the partnership interest is transferred to a taxpayer related to the ATB; and
- The tax treatment where an ATB partner that holds its interest more than three years in a partnership where 80% or more of the partnership’s assets would be characterized as short-term gain if disclosed of in a taxable transaction.
This has been a very general summary of 162 pages of the final regulations that should be read in detail in situations that include carried interest.