In the 2017 Tax Act, Congress adopted Code §1061, a provision which affects non-corporate holders of certain carried interests, which the new law refers to as applicable partnership interests (“APIs”). Under the new law, certain long-term capital gains (“LTCGs”) relating to APIs may be recharacterized as short-term capital gains (“STCGs”) unless the gains are from assets held for more than three years. LTCGs are taxed at a favorable 20% rate whereas STCGs are taxed at ordinary income rates. In January 2021, the IRS released final regulations relating to these rules that retain the structure of proposed regulations published last year, but with some significant changes.
An API is any interest in a partnership transferred to a taxpayer in connection with the taxpayer (or any related person) performing substantial services in an applicable trade or business (“ATB”) for the partnership. An ATB is any activity conducted on a regular, continuous, and substantial basis that consists of (1) raising capital and (2) purchasing investment assets (e.g., stocks, bonds) or real estate. If these rules apply, gain from a partnership’s sale of stock or other capital assets allocated to a holder of an API only gets LTCG treatment if the stock or asset was held for more than three years.
The final regulations retain the rule that recharacterization only applies to a sale of a capital asset (such as stock) and not to other types of income that is taxed at favorable capital gains rates. Such partner’s share of qualified dividend income and gain from sale of business property (so-called Section 1231 assets), which covers rental real estate, realized by the partnership will obtain LTCG treatment without limitation.
These rules also do not apply to an API that is classified as a capital interest, which requires that the partner contributed cash or other property for such interest commensurate with its value. Under the proposed regulations, the capital interest exception only applied if the interest is determined in the “same manner” as interests held by non-service partners. The final regulations relaxed that rule by only requiring that allocation and distribution rights for such interest be determined in a “similar manner” to interests held by non-service partners who have made significant aggregate capital contributions.
The proposed regulations provided that the capital interest exception will not apply to any interest acquired with a loan from the partnership, a partner or a related person or a loan guaranteed by any such person. In a taxpayer favorable change, the final regulations provide that an interest may be a capital interest even if funded by a loan from another partner (or any related person other than the partnership), provided that (1) the loan is fully recourse to the individual, (2) the individual has no right to reimbursement from any other person, and (3) the loan is not guaranteed by any other person.
These rules do not apply to APIs held by a corporation. The final regulations retain the rule that an S Corporation or a Passive Foreign Investment Company with respect to which a shareholder has made a qualified electing fund election are not eligible for this exception.
The proposed regulations had taken an expansive approach to a transfer of an API to related persons by requiring the recognition of income on the transfer even if no tax would otherwise be imposed. In a taxpayer favorable change, the final regulations eliminate that acceleration of income approach. The related party rules only will affect the character of income otherwise recognized on a taxable transfer to a related person.
As a result, a non-taxable transfer to a related person (such as by gift) will not result in recognition of income. A sale to a grantor trust that is not recognized for tax purposes will also continue to be non-taxable. By contrast, capital gain recognized on a taxable sale to a related person may result in STCG.
Any person holding a carried interest needs to keep track of these new rules in order to ensure they can obtain LTCG treatment to the fullest extent possible. Partnerships issuing such interests also need to keep track of these rules to ensure proper reporting to affected holders. Lastly, the 117th Congress will be looking for ways to fund the large cost of pandemic relief. Taxing the grant of a carried interest that has been the focus of prior legislative proposals may be one item on their list of possible revenue raisers.