Cox Castle Attorneys Address Proposed Carried Interest Regulations
October 20, 2020
On October 6, 2020, Erik Loomis and Laura Cable were contributing authors to the American Bar Association Section of Taxation’s letter entitled Comments on the Treatment of Applicable Partnership Interests Under Section 1061.
Internal Revenue Code (“Code”) section 1061, added by the Tax Cuts and Jobs Act, contains the new “carried interest” rules. These rules, which are in effect, shift the landscape for the longstanding treatment of “partnership” interests generally referred to as “promoted” or “carried” interests. At its core, section 1061 implicates the holding period that assets must satisfy in order for a carried interest owner to benefit from long-term capital gains rates.
General Treatment of Capital Gains
Generally, for investments in real estate, gain from the disposition of many types of real estate (generally, “capital assets”) result in capital gains. If a capital asset is held for more than one year at the time of sale, the resulting gain or loss is a long-term capital gain or loss. The holding period in this case is important, since a taxpayer’s annual net long-term capital gains are taxed Federally at rates that are favorable in comparison to the rates applying to “ordinary” income. In contrast, if the holding period for a capital asset is one year or less, then the resulting gain or loss on sale is a short-term capital gain or loss. Annual net short-term capital gains are taxed Federally at the same rates applying to ordinary income.
Technically speaking, most types of business real estate that give rise to capital gains are not capital assets or “ordinary” assets. Rather they fall under a third property class of “section 1231 assets”. Generally, with respect to real estate, a section 1231 asset is one used in a trade or business that is held for more than a year and is not dealer property. The effect of this rule is to take property that would otherwise be an ordinary asset and transmute it into a section 1231 asset after it has been held for more than a year. The significance of this treatment is that section 1231 assets are specially treated under a hybrid of rules applying to ordinary assets and capital assets. A taxpayer’s net annual gain from the sale of section 1231 assets is taxed at the favorable long-term capital gains rates, and a taxpayer’s net annual loss from the sale of such assets produces an ordinary loss (which is itself treated more favorably than a capital loss).
Promoted or carried interests in real estate partnerships have historically enjoyed simple flow-through treatment. If the underlying real estate of the partnership was sold, any long-term capital gain (or section 1231 gain or other gains or losses) simply flowed up to the partners. When referring to partnerships (and by extension partners) we are using tax parlance that sweeps in any entity which is treated as a partnership for income tax purposes, such as most general partnerships, limited partnerships, and multi-member limited liability companies and other entities (and the owners of such entities).
The Changes Under the Carried Interest Rules
That historic treatment for capital gains changed in 2017 with the addition of Code section 1061. The new carried interest rules impose a greater-than-three-year holding period requirement for the sale of underlying capital assets or, in the alternative, a holding period for the entity interest, with respect to any “applicable partnership interest” (API) held by a taxpayer. Generally, an API is any non-capital interest in a partnership which, directly or indirectly, is transferred to (or is held by) a non-corporate taxpayer in connection with the performance of substantial services by the taxpayer (or a related person) in any applicable trade or business. For these purposes an applicable trade or business broadly sweeps up activities relating to investing in or developing real estate held for rental or investment, among other activities. If the new, longer, holding period is not satisfied with respect to an API, what would otherwise have been taxed at the Federal long-term capital gains rates will now be taxed as short-term capital gains.
Simply put, section 1061 casts a wide net over partnership investments, including investments in real estate. Partners with carried interests in covered partnership entities should at a minimum carefully consider their exit strategies (and any available exceptions to the rules) to avoid falling afoul of the three-year rule.
On August 14, 2020, the Treasury and the I.R.S. issued proposed regulations under Code section 1061. The proposed regulations address a number of questions. While the regulations are lengthy and detailed, a few high points are worth noting.
- The rules clarify that section 1061 does not apply to so-called net “section 1231 gain”. This is an important clarification since, as noted above, businesses holding real estate often are holding the property as a section 1231 asset. Since section 1231 gains are eligible for long-term capital gains treatment, this is an important clarification.
- Section 1061 generally applies the three-year holding period in respect of the underlying assets, rather than the API itself. If the API is transferred, its holding period becomes relevant, as well as in abusive situations laid out in the proposed regulations.
- Note that even though the underlying assets of a partnership may be property the sale of which would result in section 1231 gain, the sale of a partnership interest (whether or not the interest is an API) does not under current law give rise to section 1231 gain. Taxpayers should be cautious in how an exit from an entity is structured, since it is possible to trigger the carried interest rules in one type of disposition (via the sale of an entity interest) even though a sale of the underlying assets would not fall under the rules.
- Even though the carried interest rules do not apply to “corporations” – the proposed regulations take the position that an API held by an S-corporation is subject to the rules.
- Extensive rules are included which implement the “capital interest” exception, to distinguish partnership interests which are not APIs and as to which section 1061 does not apply. The proposed regulations include detailed rules to measure the capital interest, including coordination through tiers of partnerships. These rules are particularly complex and hard to square with current practice governing tax allocations and coordinating information between tiered partnership entities. Because of this, the “capital” interest exception to the carried interest rules remains unsettled.
As is often the case where rules are concerned with classifying interests and conferring different tax treatments, the proposed rules implementing Code section 1061 are complex and raise questions. Our American Bar Association submission addressed many technical aspects of the new rules that are applied to APIs, in particular: What, if anything, distinguishes a carried interest from an API? How do you differentiate an API from a “capital” interest? How do you track the different interests during the life of the investment?
While the proposed regulations are an important step in understanding the scope of section 1061, they do not appear to be in near final form and therefore could change. With that said, it is expected that they will be finalized in the future, and the proposed regulations specify that they will apply when published in final form. In the meantime, taxpayers may rely on the proposed regulations in certain circumscribed cases.
If you have any questions about the section 1061 rules, including the rules under the proposed regulations, please do not hesitate to reach out to members of the Firm’s tax department.