Seyfarth Synopsis: On July 31, 2020, the US Department of Treasury (“Treasury”) published long-awaited proposed Treasury regulations (the “Proposed Regulations”) that provide detailed guidance on the new Code Section enacted by P.L. 115-97 (commonly referred to as the “Tax Cuts and Jobs Act”) (the “TCJA”). Unfortunately, the TJCA effectively increases the period of time that a profits interest partner must hold his, her or its profits interest in order to receive long-term capital gains treatment on disposition and capital gain allocations. While the Proposed Regulations provide some clarity on certain questions many issues are unaddressed or unresolved.
Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”), increases the holding period required for long-term capital gain upon the sale of an “applicable partnership interest” (an “API”) from 1 year to 3 years. The difference is significant for individuals and certain other non-corporate taxpayers: long-term capital gains are generally taxed at a 20% rate whereas short-term capital gains are taxed in the same manner as ordinary income (which is to say that it may be taxed at a rate as high as 37%). In effect, Code Section 1061 denies partners with an API (“API Holders”) the tax benefits associated with structuring their compensation as a carried interest for an additional 2-year period and even afterwards may prevent them from selling their API at the most opportune time.
Applicable Partnership Interests
The Proposed Regulations define an API as an interest in a partnership’s profits that, directly or indirectly, is transferred to, or held by, a taxpayer in connection with the performance of “substantial” services by the taxpayer or any other related person of the taxpayer to an entity (an “ATB Entity”) that is engaged in any applicable trade or business (an “ATB”).
Under the Proposed Regulations, a partnership interest that meets the definition of API will be an API even if it is a “profits or carried interest” that is not taxable to the receiving partner under Rev. Proc. 93-27 and Rev. Proc. 2001-43. Also, a partnership interest is an API even if it is held indirectly through one or more pass-through entities or entities that are disregarded as separate from their owner for federal income tax purposes. For this purpose, a pass-through entity includes a partnership, trust, estate, S corporation or a passive foreign investment company with respect to which the shareholder has a qualified electing fund election in effect (a “QEF”). The inclusion of an S corporation and a QEF is noteworthy because, although expected, it seems contradictory to the plain language of Code Section 1061, which excludes from the definition of API those partnership interests held by “corporations”, since both are corporations. The Proposed Regulations include a trap for the unwary: if a pass-through entity holds an API and a new owner contributes to that pass-through entity, the API characterization will apply to that new owner even if the new owner is unrelated and does not provide services to the ATB Entity. There is also a timing component: if a partnership interest is transferred to a partner who is expected to provide substantial services to the partnership, but, at the time of the transfer the partnership has not yet engaged in an ATB, then the partnership interest is not yet an API and only becomes an API when the partnership becomes an ATB Entity and the partner begins providing substantial services to it.
The API characterization is durable since a partnership interest will not cease to be an API even if the partner or a person related to the partner stops providing “substantial” services or any services to the ATB Entity and even if the partner retires. Generally speaking, the API characterization only ceases if one of the exceptions to the definition of API applies. These exceptions include: (1) as noted above, any partnership interest that is directly or indirectly held by a corporation (but not an S corporation or a QEF); (2) certain capital interests (i.e., interests in the capital rather than the profits of a partnership); (3) certain partnership interests held by an employee of an entity that is not an ATB Entity; and (4) a partnership interest (even if it was previously an API) acquired by an unrelated third party for fair market value who will not provide services to the ATB Entity. The Proposed Regulations make it clear that a partner can have an interest in an ATB Entity that is both an interest in the capital of the ATB Entity and an API and provide rules for determining which part of the gain or loss is attributable to the capital and which portion is attributable to the API. However, the rules may be somewhat burdensome as they require the ATB Entity to determine how allocations of unrealized gain and loss would be made to the API Holder upon a taxable disposition of all of its underlying property under the capital account revaluation rules. ATB Entities that undertake such an exercise are permitted to leave their capital accounts revalued for non-Code Section 1061 purposes.
The Proposed Regulations presume that services performed in connection with transfer of a partnership interest are substantial. This presumption is based on the assumption that the parties have economically equated the services performed with the potential value of the partnership interest transferred. The Proposed Regulations do not address the question of if and how such presumption can be rebutted.
Applicable Trade or Business
An ATB is defined as any activity conducted on a regular, continuous, and substantial basis which consists, in whole or in part, of (1) raising or returning capital and (2) investing in, disposing of, or identifying (for such investment or disposition) “specified assets” or developing “specified assets”. An activity is conducted on a regular, continuous, and substantial basis if the total level of activities meets the level of activity required to establish a trade or business under Code Section 162. Specified assets are securities, commodities, real estate held for rental or investment, cash or cash equivalents, an interest in a partnership to the extent it holds specified assets, and options or derivative contracts with respect to the foregoing. The Proposed Regulations include an example demonstrating that real estate used in a trade or business for non-rental and non-investment purposes is excluded from the definition of an ATB. An entity is developing specified assets if a representation is made to investors, lenders, regulators, or others that the value, price, or yield of a portfolio business may be enhanced in connection with the choices or actions of a service provider or of others acting in concert with or at the direction of a service provider.
If an API Holder sells an API when held for three years or less, then Code Section 1061 recharacterizes the capital gain that would have been long-term under the general rules as short-term capital gain. A taxpayer’s net long-term capital gain from API transfers during a taxable year includes both long-term capital gain and loss from actual or deemed disposition of APIs and net distributive share of long-term capital gain or loss from all APIs held through pass-through entities (collectively, “API Gains and Losses”). API Gains or Losses does not include: (1) long-term capital gains and losses with respect to a capital investment; (2) long-term capital gains or losses determined under Code Sections 1231, 1256 or otherwise without regard to the holding period rules of Code Section 1222 (e.g., mixed straddle rules under Code Section 1092); and (3) qualified dividends under Code Section 1(h)(11)(B). Section 1061 does not apply to any gains or losses that are treated as ordinary income under the Code (e.g., Code Sections 751 and 1245).
If an API Holder transfers the API to a “related party,” then the API Holder recognizes short-term capital gain equal to the excess, if any, of (1) the API Holder’s net long-term capital gain distributive share had the ATB Entity sold all its assets with a holding period of three years or less in a fully taxable transaction for their fair market value in cash immediately prior to such transfer, over (2) the amount of the long-term capital gain recognized on the transfer that is treated as short-term capital gain under Code Section 1061. A transfer includes, but is not limited to, contributions, distributions, sales and exchanges, and gifts without regard to whether the transfer is otherwise a taxable event. A related party includes only members of the API Holder’s family (i.e., spouse, children, grandchildren, and parents), colleagues (i.e., those who provided services to the ATB Entity during certain time periods), and a pass-through entity to the extent that a member of the ATI holder’s family or a colleague is an owner of the pass-through entity. However, a contribution to a partnership is not treated as a transfer to a related party.
The Proposed Regulations provide that even if an API Holder sold an API in an installment sale initiated prior to the enactment of Code Section 1061, the recharacterization rules of Code Section 1061 will still apply to post-enactment payments.
Once the API Holder has held the API for more than three years, Code Section 1061 should no longer recharacterize any long-term capital gain recognized on the sale of the API. However, API Holders who have held their API for the requisite three year holding period will need to be careful of a look-through rule in the Proposed Regulations. The Proposed Regulations provide that if, at the time an API Holder sells the API, 80% or more (by value) of the assets held by the ATB Entity have been held for three years or less, then a corresponding percentage of the API Holder’s capital gain will be classified as short-term capital gain.
Distributions of Assets to an API Holder
Generally, if a partnership, including an ATB Entity, disposes of its assets, then the partnership’s holding period for that asset controls for determining long-term and short-term treatment. This includes an API held by a partnership.
A distribution of an ATB Entity asset to an API Holder will not be treated as a full or partial API sale that implicates Code Section 1061. However, if the API Holder sells that distributed asset before the combined asset holding period of the ATB Entity pre-distribution and the distributee partner post-distribution is greater than three years, then the Code Section 1061 rules apply to the asset sale. The long- or short-term gain is included in the income of the seller whether that seller is an individual or a pass-through entity between the individual and the ATB Entity.
RIC and REIT Capital Gain Dividends Disclosure
The Proposed Regulations clarify that RIC and REIT capital gain dividends a partnership receives are in fact subject to the rules of Code Section 1061. In the absence of the additional disclosure described below, the entire amount of such capital gain dividends has to be treated as long-term capital gains from assets held for 3 years or less.
The Proposed Regulations allow, but do not require, RICs and REITs that distribute capital gain dividends to disclose to each shareholder (i) the portion attributable to net capital gain subject to Code Section 1061 and not otherwise excluded, and (ii) the portion attributable to net capital gain subject to Code Section 1061 and not otherwise excluded, assuming the holding period in Code Section 1222 was 3 years. Both amounts so disclosed have to be proportionate to the recipient partnership’s share of the capital gain dividends reported or designated for the taxable year. If such disclosure is made, the recipient partnership has to use the disclosed amounts in applying Code Section 1061.
Finally, the Proposed Regulations provide that any loss on the sale or exchange of the shares of such a disclosing RIC or REIT held for 6 months or less, has to be treated as a capital loss on an asset held for more than 3 years to the extent of the amount described in clause (ii) above.
The Proposed Regulations do not apply until they are published as final Treasury regulations in the Federal Register. However, a taxpayer may rely on the Proposed Regulations until that time if the taxpayer applies them in their entirety and in a consistent manner. Further, the Proposed Regulations state that, as indicated in Notice 2018-18, the rule that S corporations are not corporations for purposes of Code Section 1061 would be applicable for tax years beginning after December 31, 2017, and that the rule that QEFs are not corporations for purposes of Code Section 1061 would be applicable for tax years beginning after August 14, 2020.
Open Question: Carry Waivers
The Preamble of the Proposed Regulations flags certain structures that “may not be respected”, but does not specifically state that they will not be respected. Thus, the Proposed Regulations mention carry waivers or carried interest waivers pursuant to which an API Holder may waive the right to an allocation of capital gains from all assets in favor of an allocation of capital gains from assets held for more than three years and/or a priority fill up allocation designed to replicate the economics of an arrangement in which the API Holder shares in all realized gains over the life of the fund. The Preamble simply states that these arrangements “may not be respected” and “may be challenged under section 707(a)(2)(A), §§ 1.701-2 and 1.704-1(b)(2)(iii), and/or the substance over form or economic substance doctrines”. Thus, API Holders are left to wonder whether these arrangements will be challenged.