IRS Releases Proposed Regulations re: Carried Interests – Profit Sharing Interests in Partnerships

October 21, 2020

IRS Releases Proposed Regulations re: Carried Interests – Profit Sharing Interests in Partnerships

Proposed regulations confirm and clarify many aspects of the 2017 law change

On July 31, 2020 the Internal Revenue Service (IRS) released proposed regulations under IRC Section 1061 on the treatment of carried interests. Carried interests are ownership interests in a partnership that share in the partnership’s net profits. They are often transferred in connection with the performance of substantial services by an individual. Carried interests have been controversial since income from that individual’s partnership interest are often taxed as capital gains rather than ordinary income.

IRC Section 1061 was enacted in 2017 as part of the Tax Cuts and Jobs Act (TCJA), and extended the holding period for certain carried interests, applicable partnership interests (APIs), from one year to three years to be eligible for capital gain treatment.

Holding period determined by partnership asset NOT partnership interest
Consistent with current law, the Proposed Regulations generally look to the holding period of the asset being sold to determine whether the three-year holding period is satisfied. That is, if a partner has an applicable partnership interest (API) in a partnership, and the partnership sells an asset, the relevant holding period is that of the partnership in the asset, not that of the partner in the partnership.

Treatment of qualified dividends to an applicable partnership interest holder and certain business capital gains remain the same
The Proposed Regulations did not change the rules for qualified dividends, which are eligible for long-term capital gains rates if received by an API holder without any special holding period, or for straddle contracts under IRC Section 1256. In addition, capital gains on property used in a trade or business (such as intangible gains) are also excluded from the application of new Section 1061.

Summary of other key provisions in the Proposed Regulations
The six sections of the proposed regulations cover definitions of terms, an explanation of rules and examples, exceptions to the definition of an applicable partnership interest, computation of recharacterized income, related party rules, and proper reporting of recharacterized income.

In addition, a large portion of the Proposed Regulations focused on potential anti-avoidance transactions.

For example, where an individual owns an API indirectly through another flow-through entity, special holding-period rules apply Similarly, if a service provider receives a distribution of property with respect to an API, the Proposed Regulations provide that the property maintains the API taint, even though it might not itself be an API. Accordingly, any transaction involving an API will need to be reviewed carefully to determine the potential application of Section 1061.

The proposed regulations also include clarifying amendments to Regs. Sec. 1.702-1(a)(2), (Income and Credits of a Partner) and Regs. Sec. 1.704-3(e), (Contributed Property).

The proposed regulations contain a transition rule for partnership property that was held by the partnership for more than three years on Sec. 1061’s effective date. Under the transition rule, a partnership that was in existence as of January 1, 2018 may elect to exclude from the recharacterization rule all long-term gains and losses from assets held more than 3 years as of January 1, 2018.

Confirmation of rule prohibiting the use of an S corporation to avoid the 3-year holding period
On March 1, 2018, the IRS issued Notice 2018-18, attempting to close a loophole that was identified by some taxpayers to allow for long-term capital gain treatment only after one year if the carried interest was transferred to an S Corporation rather than directly to an individual.

This notice stops taxpayers from using an S corporation to avoid the carried interest rules by saying that, for purposes of the carried interest rules, a “corporation” for purposes of Sec. 1061(c)(4)(A) does not include an S corporation. Under Sec. 1061(c)(4)(A) an API does not include any interest in a partnership that is directly or indirectly held by a corporation. The proposed regulations reemphasize this provision, clarifying that partnership interests held by S corporations are treated as APIs if the interest otherwise meets the API definition.

Effect and applicability of the Proposed Regulations
These proposed regulations generally confirm the provisions in the 2017 law change regarding carried interests and provide some guidance as to how to apply the new law.

While the carried interest tax law changes and these Proposed Regulations only affect a relatively small group of taxpayers, it is worthwhile to keep aware of tax policy regarding this this controversial topic and to follow IRS interpretations and policies related to it.

Please contact your Herbein tax consultant if you have questions at info@herbein.com. Article prepared by Neil Winter.