For carried interests that are applicable partnership interests, the Tax Cuts and Jobs Act of 2017 effectively extended the capital-gains holding period from one year to three years. The three-year period applies regardless of Code Sec. 83 and any Code Sec 83(b) election in effect. Thus, income from a carried interest is generally taxed as short-term capital gain, which means the tax rate for ordinary income applies. These rules apply to tax years beginning after December 31, 2017.
The IRS plans to issue regulations clarifying the new three-year holding period for certain carried interests. The new regulations will provide that partnership interests held by S corporations are subject to the extended three-year holding period for applicable partnership interests imposed by new Code Sec. 1061.
Carried interests are ownership interests in a partnership that share in the partnership’s net profits. They are often issued to investment managers in connection with the manager’s services. The receipt of a partnership profits interest for services is usually a nontaxable event. Income from the carried interest, which tends to be in the range of 20 to 25 percent of profits, may be short-term or long-term capital gain realized by the underlying investment fund as it sells off investment assets. Thus, the interest may be taxed at a lower rate than ordinary income.
Applicable Partnership Interest
An applicable partnership interest is a partnership interest that is transferred to or held by the taxpayer in connection with the performance of services by the taxpayer or a related person in any applicable trade of business, even if the taxpayer made contributions to the partnership. An applicable trade or business is one whose regular business activity consists of: (1) raising or returning capital; and (2) investing in, disposing of or developing specified assets. Specified assets are securities, commodities, real estate held for rental or investment, cash or cash equivalents, or options or derivative contracts with respect to these assets, as well as a partnership interest to the extent of the partnership’s proportionate interest in specified assets.
However, an applicable partnership interest does not include: (1) a partnership interest held by a corporation; or (2) a capital interest in the partnership that provides the taxpayer with a right to share in partnership capital based on the amount of capital contributed or on the value of the interest subject to tax under Code Sec. 83 when the interest is received or vested.
The IRS intends to issue regulations providing that an S corporation is not a corporation for purposes of the rules that excludes a corporation’s partnership interest from applicable partnership interests. Since a partnership interest held by an S corporation will not be an interest held by a corporation, the interest can be an applicable partnership interest. This rule will prevent taxpayers from using S corporations to circumvent the three-year holding period.
The regulations will be effective for tax years beginning after December 31, 2017.
There is talk on Capitol Hill that Congress and Treasury may not see eye to eye on the forthcoming regulations. Senate Finance Committee (SFC) Chairman Orrin G. Hatch, R-Utah, said in a recent SFC hearing that it is up to Congress to interpret any ambiguities in the new tax law.
“I’m going to keep working to ensure that everyone recognizes and respects Congress’ role in this process and the fact that the best place to get an explanation of Congress’s intent is Congress itself,” Hatch said. “Where things are potentially unclear in the law, Congress should be the one to determine and explain what was intended and, if need be, such as with section 199A, provide a timely fix.”
Congress may move forward with a technical corrections bill later this year to fill some of the gaps within the tax reform legislation, according to Steven M. Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center. However, the IRS “cannot simply ignore the statute and rewrite the tax law,” Rosenthal said on March 1. “Chairman Hatch is right, Congress holds the pen.”