One unfavorable tax change in the Tax Cuts and Jobs Act (TCJA) was the extension of the holding period for capital gains treatment from 1 to 3 years for carried interests. Carried interests are profits interests held by investment fund managers that compensate them for their services and are commonly used by private equity, venture capital and real estate investment funds. The usual model is that the fund managers get a 20% profits interest in the entity. How the holding period rules apply to different types of interests is the subject of long-awaited regulations recently released by the IRS.
What is and is not an API
Section 1061, the carried interest section, applies to “applicable partnership interests” (APIs), defined as any interest in a partnership which is transferred to or is held by the taxpayer in connection with the performance of substantial services by the taxpayer, or a related person, in an “applicable trade or business.” An applicable trade or business is one conducted on a regular, continuous, and substantial basis which consists of 1) raising or returning capital; and 2) investing in or disposing of specified assets or developing specified assets, including securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts, for these assets.
Early on, there was confusion about whether these rules applied to S Corporations because an exception exists for partnerships directly or indirectly held by a corporation. In early 2018, Treasury and the IRS issued a statement and official Notice informing taxpayers that S Corporations are not included in this exception and taxpayers cannot avoid the three-year holding period by using S Corporations. The new regulations confirm this interpretation and indicate that passive foreign investment companies that have made a qualified electing fund election also are excluded from the exception and are therefore subject to the 3-year rule. The regulations further explain which other kinds of interests are and are not subject to the longer holding period.
The interests identified as not being subject to the 3-year rule include:
- Sec. 1231 gain from business assets
- Gain from Sec. 1256 marked-to-market contracts
- Qualified dividends
- Gains classified as mixed straddles
- REIT and RIC capital gain dividends
The rules provide complex reporting requirements for partnerships and directions for determining the extent to which partners’ allocations are subject to the 3-year holding period rule. Related party rules and recharacterizations also are addressed.
Finally, the regulations caution taxpayers about using carry waivers to circumvent Section 1061 by waiving their rights to gains generated from the disposition of a partnership’s capital assets held for three years or less and substituting gains generated from capital assets held for more than three years. These and similar arrangements may be challenged by the IRS under the substance over form or economic substance doctrines, the IRS notes.
Taxpayers may rely on the regulations until they are finalized. The IRS is asking for public comments on whether a simplified method for determining and calculating the API gain or loss should be provided for smaller partnerships and what criteria should be used to determine which partnerships are eligible to use the simplified method.
The 162 pages of regulations are highly technical but important for fund managers and certain partnerships. A three-year holding period in return for capital gains rates is an investor burden, but there are some exceptions as defined by the new regulations.
If you have questions about carried interest and the new regulations, please reach out to your Frazier & Deeter tax professional.