On January 7, 2021, Treasury released tax regulations that clarify provisions enacted as part of the Tax Cuts and Jobs Act of 2017, which placed limits on the tax benefits associated with carried interests. To create a greater sense of fairness among taxpayers, these rules impose a three-year holding period requirement, rather than the standard one-year holding period requirement, in order to receive long-term capital gain (LTCG) treatment (and associated preferential tax rates for non-corporate taxpayers) with respect to certain capital gains realized in connection with so-called “applicable partnership interests” (APIs). In general, APIs are partnership interests held by service providers or related parties.
This applies to fund managers who provide services in order to share in the fund’s profits, also known as a carried interest (or incentive allocation).
The top rate applicable to LTCG (currently 20%) is substantially lower than the top ordinary rate (currently 37%) and is, therefore, a material consideration for managers of investment partnerships.
Treasury made several significant changes in the rules, many of which are to the benefit of taxpayers. However, certain questions remain.
A highlight of changes follows:
1. A carve-out known colloquially as the “family office exception” remains reserved in the final regulations. The statute, in section 1061(b), provides regulatory authority to establish an exception to the special three-year holding period rule for income or gain attributable to any asset that isn’t held for investment on behalf of any “third-party investor” (generally speaking, an investor that isn’t related to the service provider holding the API and whose interest does not, itself, constitute an API). However, this exception doesn’t become effective until it is activated through regulations or other guidance and therefore remains uncertain.
2. Debt-financed capital contributions are taken into account for purposes of the capital interest exception. The proposed regulations stated that a capital account didn’t include the contribution of amounts attributable to a loan made or guaranteed by the partnership, a partner, or a related person. In the fund context, this position is problematic due to the frequency with which employees are granted loans in order to invest in the funds. Under the final regulations, a capital contribution by an individual service provider that is attributable to a loan or advance from another partner in the partnership (or related person) is included for purposes of applying the “capital interest exception,” if the individual service provider is personally liable for the repayment of the loan.
3. The three-year holding period rule does not apply to a partnership interest (or portion thereof) with respect to which allocations of capital gain or loss are made based on the relative capital accounts of the partners. The proposed regulations provided that accepted capital interest allocations must be made to all partners in the same manner. The final regulations take the more taxpayer-friendly position that capital interest allocations must be commensurate with capital contributed to qualify for the exception.
4. Clarification that S corporations are treated like other flow-through businesses (and are not carved out of the statute like C corporations).
5. There remains a carve-out treating section 1231 and certain real estate gains as LTCG regardless of holding period. This is of considerable importance for real estate funds and their managers.
6. The final regulations removed a provision in the proposed regulations that treated the transfer of an API to a related person in an otherwise non-taxable transaction as an acceleration event under section 1061(d). The statute provides that transfers of APIs to related parties are treated as taxable transfers to which the three-year holding period may apply. The proposed regulations interpreted this to include nontaxable transfers (such as gifts), posing a challenge to common intra-family transfers. Treasury has determined that it is more appropriate to apply this provision only to transfers in which gain is otherwise recognized.
These clarifications are valuable, but still omit the important family office exception.