IRS clarifies holding period rules for profits interests and carried interests

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The Internal Revenue Service (the “IRS”) issued proposed regulations (the “Proposed Regulations”) that govern the tax treatment of certain equity interest under Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”). Specifically, the Proposed Regulations clarify certain applications of the three-year holding period rules and, as a result, taxpayers may need to reconsider certain aspects of profits interests and carried interests awards.

Background

Before the passage of the Tax Cuts and Jobs Act of 2017 (the “TCJA”), profits interests and carried interests received in connection with the performance of services held by a taxpayer for more than one year were eligible for preferential long-term capital gains rates rather than ordinary income rates. The TCJA added Section 1061 to the Code, which generally provides that profits interests and carried interests with respect to an “applicable trade or business” are treated as an “applicable partnership interest” (“API”), all or a portion of which may be recharacterized and treated as short-term capital gains.

Section 1061 defines an “applicable trade or business” as any activity conducted on a regular, continuous, and substantial basis which consists of (A) the raising or returning of capital and (B) either (i) investing in or disposing of “specified assets” (or identifying specified assets for such investing or disposition) or (ii) developing “specified assets.” “Specified assets” are defined as securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing. The definition of “specified assets” does not include operating businesses.

Under the Proposed Regulations, once a partnership interest is an API, it remains an API and never loses that character unless an exception applies.

Applicable trade or business

An activity is considered to be conducted on a regular, continuous and substantial basis if (1) it is conducted by one or more related persons and (2) rises to the level of activity to establish a trade or business for purposes of Section 162. In general, the buying, holding and selling activities of private equity and venture capital funds have been held not to rise to the level of a trade or business. In addition, the activities of hedge funds have been held not to rise to the level of a trade or business. Therefore, Section 1061 and the Proposed Regulations may have limited application given the high standard to create a “trade or business” for purposes of Section 162 (i.e., profits interests and carried interests would not be subject to the API rules).

Corporation Exception

Section 1061 provides an exception to the API rules for profits interests and carried interests held (directly or indirectly) by a corporation (the “Corporation Exception”). In response to the Corporation Exception, because S corporations are pass-through in nature and “corporations,” some taxpayers established S corporations to hold their profits interests and carried interests and avoid application of the API rules. In an attempt to limit the use of this exception and close a “loophole,” the Proposed Regulations clarify that an S corporation is not included as a “corporation” for purposes of Section 1061 such that profits interests held by taxpayers through S corporations are still subject to the API rules. However, a number of practitioners have argued that it is up to Congress and the President (rather than the IRS) to amend Section 1061.

Capital Interest Exception

The Proposed Regulations provide that “capital interest gains and losses” are not subject to the API rules (the “Capital Interest Exception”). To qualify for this exception, the Proposed Regulations require that (i) the terms of the partnership agreement provide for allocations based on the relative capital accounts of the partners receiving the allocations, and (ii) the terms, priority, type and level of risk, rate of return and rights to cash or property distributions during the partnership’s operations and on liquidation must be the same as for non-service-provider partners.

For purposes of determining capital accounts of partners for the Capital Interest Exception, the Proposed Regulations state that a capital account does not include the contribution of amounts attributable to any loan or other advance made or guaranteed (directly or indirectly) by any other partner or the partnership (or any person related to any such other partner or the partnership).

Third Party Acquisition Exception

The Proposed Regulations add an exception for unrelated taxpayers who acquire an API (the “Third Party Acquisition Exception”). Specifically, an interest in a partnership that is treated as an API, but is purchased by an unrelated buyer for fair market value, is not an API with respect to the buyer if (1) the buyer does not currently and has never provided services in the relevant active trade business (or to the passthrough entity in which the partnership interest is held), (2) the buyer does not contemplate providing services in the future and (3) the buyer is not related to a person who provides services currently or has provided past services. However, to the extent a non-service provider becomes a partner by making a contribution to a passthrough entity, the Third Party Acquisition Exception does not apply.

Employee exception

Section 1061(c)(1) provides an exception for certain partnership interests held by employees of entities that are engaged in a trade or business (other than an applicable trade or business). The Proposed Regulations track the statutory language.

Holding period

The Proposed Regulations adopt the approach that the holding period of the owner of the asset sold controls.

Asset sales by partnerships

With respect to sales of assets by partnerships (whether the asset disposed is an API itself or an underlying capital asset held by the partnership), the holding period of the partnership controls. This rule is illustrated by the following examples.

  • Example 1 (Short-Term Equity and Short-Term Asset): Assume the following facts: (1) Partner A holds an equity interest in Partnership, Partner A’s equity interest is an API, Partner A has held the equity interest for 2 years and Partner A does not have a capital account; (2) Partner B holds an equity interest in Partnership, Partner B’s equity interest is not an API, Partner B has held the equity interest for 5 years and Partner B does have a capital account; (3) Partnership sells Asset X (held for 2 years and not an API) that generates a long-term capital gain of $1,000; and (4) the $1,000 long-term capital gain is allocated $200 to Partner A and $800 to Partner B.  Based on the foregoing, because the Partnership held Asset X for 3 years or less, (i) the $200 long-term capital gain allocated to Partner A is subject to recharacterization as a short-term capital gain, but (ii) the $800 long-term capital gain allocated to Partner B is not subject to recharacterization as a short-term capital gain.
  • Example 2 (Long-Term Equity and Short-Term Asset): Assume the same facts as Example 1 except that Partner A held its equity interest for 4 years. Based on the foregoing, because the Partnership held Asset X for 3 years or less, (i) the $200 long-term capital gain allocated to Partner A is subject to recharacterization as a short-term capital gain, but (ii) the $800 long-term capital gain allocated to Partner B is not subject to recharacterization as a short-term capital gain.
  • Example 3 (Short-Term Equity and Long-Term Asset): Assume the same facts as Example 1 except that the Partnership held Asset X for 4 years. Based on the foregoing, because the Partnership held Asset X for more than 3 years, (i) the $200 long-term capital gain allocated to Partner A is not subject to recharacterization as a short-term capital gain, and (ii) the $800 long-term capital gain allocated to Partner B is not subject to recharacterization as a short-term capital gain.
  • Example 4 (Long-Term Equity and Long-Term Asset): Assume the same facts as Example 1 except that Partner A held its equity interest for 4 years and the Partnership held Asset X for 4 years. Based on the foregoing, because the Partnership held Asset X for more than 3 years, (i) the $200 long-term capital gain allocated to Partner A is not subject to recharacterization as a short-term capital gain, and (ii) the $800 long-term capital gain allocated to Partner B is not subject to recharacterization as a short-term capital gain.
  • Example 5 (Asset is an API): Assume the same facts as Example 1 except that Asset X is an API (i.e., a partnership interest held for 3 years or less). Based on the foregoing, (i) the $200 long-term capital gain allocated to Partner A is subject to recharacterization as a short-term capital gain, and the (ii) the $800 long-term capital gain allocated to Partner B is subject to recharacterization as a short-term capital gain.

API equity sales

With respect to sales of equity by partners, the Proposed Regulations state that, except to the extent the lookthrough rule applies, the holding period of the API partner controls for purposes of Section 1061. In the case of a disposition of a directly held API with a holding period of more than three years, the lookthrough rule applies if the assets of the relevant partnership satisfy the substantially all test (i.e., 80% or more of the assets of the relevant partnership have a holding period of three years or less). The lookthrough rule set forth in the Proposed Regulations recharacterizes a portion of the gain from the sale of the API as short-term based on the underlying partnership assets.

Given the holding period rules set forth in the Proposed Regulations, API partners disposing of a business should analyze whether it is more tax-efficient for the partnership to sell its assets or the API partners to sell their equity. Depending on the facts, each transaction may result in different tax consequences to the partners.

Private equity funds considering future structures, should consider whether to use an LLC holding company that owns a wholly-owned corporate subsidiary. Under the Proposed Regulations, once the wholly-owned corporate subsidiary has been owned for more than three years, new grants of profits interests and capital interests in the top-tier LLC could avoid application of the API rules. However, the sale of a wholly-owned corporate subsidiary may not be as attractive to buyer because such acquisition would not provide a basis step-up in the underlying assets.

Other guidance

The Proposed Regulations also provide the following additional guidance on the application of the Section 1061 three-year holding period.

In-kind distributions

In-kind distributions are not exempt from the three-year holding period, and a partnership that distributes property in kind to an API partner will only receive long-term capital gain rates on gain from the sale of the distributed property if such property has been held cumulatively for at least three years.

Excluded gains

Section 1061 does not apply to certain qualified dividend income, Section 1231 capital gains from the sale of property used in a trade or business, or mark-to-market contracts under Section 1256.

Given the complexity of the Proposed Regulations, taxpayers should contact their tax advisors with any questions related to how the Proposed Regulations may impact their current and proposed transactions.

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