by Curtis Kim
The Tax Cuts and Jobs Act of 2017 (“TCJA”) introduced several tax provisions and made significant changes to existing tax law. One major provision is section 1061, which is commonly referred as the Carried Interest Legislation. Section 1061 intends to prevent certain taxpayers from paying taxes at the lower long-term capital gain tax rates by utilizing various partnership tax rules. Section 1061 is generally effective for tax years beginning after Dec. 31, 2017.
The IRS issued proposed regulations under section 1061 on July 31, 2020. This Tax Alert will explain some of specifics, the effects of these proposed regulations and the overall effects of the Carried Interest Legislation.
The basic construct of section 1061 (click here for the full text) is that when a taxpayer disposes of one or more applicable partnership interests (API), even if the resulting gain would have been a long-term capital gain under the normal one-year holding period requirement, such gain will be treated as a short-term capital gain if the holding period is three years or less. This treatment will generally subject the gain to higher tax rates since a short-term capital gain is generally subject to the ordinary income tax rates.
For example, for a married filing joint taxpayer, a net capital gain tax rate of 20 percent applies to the extent the taxpayer’s taxable income exceed $488,850 in 2020. On the contrary, the highest federal income tax rate for ordinary income is 37 percent for income over $622,050 in 2020 for married filing jointly taxpayers. Assuming a taxpayer is subject to the highest long-term capital gain and ordinary income tax rates, $1 million of what would have been a long-term capital gain re-characterized as a short-term capital gain may result in $170,000 of additional federal income tax.
The proposed section 1061 regulations have clarified several questions and uncertainties.
What is API?
- It is defined as “…any interest in a partnership which, directly or indirectly, is transferred to (or is held by) an Owner Taxpayer or Passthrough Taxpayer in connection with the performance of substantial services by the Owner Taxpayer or by a Passthrough Taxpayer, or by any Related Person, including services performed as an employee, in any ATB unless an exception in §1.1061-3 applies.”
- Here, ATB means Applicable Trade or Business, which is “…any activity for which the ATB Activity Test with respect to Specified Actions is met and includes all Specified Actions taken by Related Persons, including combining activities occurring in separate partnership tiers or entities as one ATB.”
- There are a few more definitions within the proposed regulations, but a taxpayer may meet the ATB Activity Test if the taxpayer regularly engages in raising or returning capital for investing or developing the following types of assets (defined “Specified Assets”):
- Securities, including interests in partnerships qualifying as securities (as defined in section 475(c)(2) without regard to the last sentence thereof);
- Commodities (as defined in section 475(e)(2));
- Real estate held for rental or investment;
- Cash or cash equivalents; and
- An interest in a partnership to the extent that the partnership holds Specified Assets.
- Securities under section 475 include stock in a corporation, publicly traded partnership, note, bond, debenture or other evidence of indebtedness and certain other financial instruments.
- A welcoming clarification from the proposed regulations is that the definition of Specified Assets does not seem to include investments in operating partnerships that are engaged in a non-ATB businesses:
|(vi) Example 6. ATB Activity Test not satisfied. A is the manager of a hardware store. Partnership owns the hardware store, including the building in which the hardware business is conducted. In connection with A’s services as the manager of the hardware store, a profits interest in Partnership is transferred to A. Partnership’s business involves buying hardware from wholesale suppliers and selling it to customers. The hardware is not a Specified Asset. Although real estate is a Specified Asset if it is held for rental or investment purposes, Partnership holds the building for the purpose of conducting its hardware business and not for rental or investment purposes. Therefore, the building is not a Specified Asset as to Partnership. Partnership also maintains and manages a certain amount of working capital for its business, but actions with respect to working capital are not taken into account for the purpose of determining whether the ATB Activity Test is met. Partnership is not a Related Person with respect to any person who takes Specified Actions. Partnership is not engaged in an ATB because the ATB Activity Test is not satisfied. Although Partnership raises capital, its Raising or Returning Capital Actions alone do not satisfy the ATB Activity Test. Further, Partnership takes no Investing or Developing Actions because it holds no Specified Assets other than working capital. Partnership is not in an ATB and the profits interest transferred to A is not an API.|
GHJ Observation #1: This example indicates that a partnership does not conduct ATB Activity and hence is not subject to section 1061 because the partnership is not engaged in investing or developing Specified Assets. It goes so far to imply that working capital and/or real property used in the non-Specified Asset business should not count.
GHJ Observation #2: Under section 1061, there will be two different holding periods (one year and three years) that certain taxpayers will have to grapple with. Given several tax rules related to tacking on holding periods, GHJ recommends relevant taxpayers closely evaluate their holding periods.
What happens if one has an API?
- Generally, any gain from the disposition of an API, including gain flowing up from the lower-tier partnership, would be treated as a short-term capital gain if the three-year holding period requirement is not met.
|(i) Example 1. Calculation of the API One Year Distributive Share Amount and the API Three Year Distributive Share Amount--(A) Facts. A holds an API in PRS. A does not have a capital account in PRS for purposes of §1.1061-3(c)(3)(ii). During the taxable year, A is allocated $20 of long-term capital gain recognized by PRS on the sale of capital asset X held by PRS for two years. A is allocated $40 of long-term capital gain from the sale of capital asset Y held by PRS for five years. Assume A has no other items of long-term capital gain or loss with respect to its interest in PRS during the taxable year. Accordingly, A is allocated $60 of long-term capital gain from PRS under §1.702-1(a)(2) for the taxable year. A has no other long-term capital gains or losses with respect to an API during the taxable year.|
What Others in the Proposed Regulations?
- The proposed regulations contain many other important aspects of section 1061, including certain clarification on tiered partnership structure, transfer of API to a related party and reporting requirements.
Please contact a GHJ tax advisor
with any questions or to discuss how the proposed tax changes may affect you or your business.
Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and all Regulation section references are to the Treasury Regulations promulgated thereunder
The proposed regulations have five exceptions from the definition of API, notably:
- an interest held by a person who is employed by another entity that is conducting a trade or business that is not an ATB and provides services to such other entity;
- partnership directly or indirectly held by a C corporation;
- any capital interest in the partnership;
- to the extent provided by the Secretary, section 1061 does not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third party investors;
- an unrelated purchaser who is a non-service provider.