Peter M. Fass

On Dec. 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act (Pub. L. 115-97 (Tax Act) into law. The Tax Act enacted the most sweeping changes to the Internal Revenue Code (Code) since the Tax Reform Act of 1986. One of the changes is to the taxation of carried interests. This article will discuss an overview of the provisions of the Tax Act applicable to carried interests.

Normally, the fair market value of property received in exchange for services is income, subject to the rules of Code §83. There is an exception in partnership taxation. Rev. Proc. 93-27 provides that the receipt of a future profits interest in a partnership in exchange for services is normally not income. See Rev. Proc. 93-27, 1993-2 C.B. 343; and Rev. Proc. 2001-43, 2001-2 C.B. 191. Rev. Proc. 93-27 identifies some circumstances in which the safe harbor does not apply. A service provider whom receives the profits interest is taxable on the share of the profits as earned but is not taxable on the receipt of the profits interest itself. That profits interest is called a “carried interest” (sometimes it is called a “promote”).

The 2017 Tax Act restricts the potential tax benefit of carried interests by limiting the availability of long-term capital gain rates. Under this restriction, a person must use a three-year holding period for partnership assets to determine whether gains from certain partnership interests qualify for long-term capital gain treatment. Amounts that are disqualified under this rule are instead treated as short-term capital gain, subject to rates that equal ordinary income rates. The restriction applies to partnership interests that are received in connection with performing services for a business that consists in whole or in part of (1) raising or returning capital and either (2) investing in (or disposing of) specified assets (or identifying specified assets for investing or disposition) or (3) developing specified assets.

Specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, and derivatives that reference any of the foregoing, or an interest in a partnership to the extent of the partnership's interest in the forgoing assets. The activity may be conducted in one or more entities. The House Committee on Ways and Means report on the House's initial tax bill states that interests in privately held partnerships are “specified assets” for this purpose. See Conference Report to Accompany H.R. 1, Tax Cuts and Jobs Act, 115th Congress, 1st Session, Rept. 115-466 (Dec. 15, 2017) (Conf. Rep.).

The restriction does not apply where a partnership interest generates a capital loss, rather than capital gain, for a tax year. It also does not apply to partnership interests held directly or indirectly by a corporation or certain capital interests in partnerships.

The Tax Act requires that, for applicable partnership interests (API), in order to obtain long-term capital gain treatment, the required asset-holding period must be greater than three years. The three-year holding period is required for sales of assets held (directly or indirectly) by the applicable partnership. In the case of the sale of an API, it appears that this three-year holding period also would apply with respect to the API itself.

Rather than treating amounts failing the three-year test as ordinary income, as has been the typical re-characterization under prior versions of carried interest legislation, the Tax Act treats such gain as short-term capital gain. The short-term capital gain treatment under the three-year holding rule applies notwithstanding Code §83 or any election in effect under Code §83(b). The Conf. Rep. at 269 provides that the fact that a taxpayer has included an amount in income under Code §83 upon the acquisition of an API or has made an election under Code §83(b) with respect to such an interest does not change the three-year holding period requirement for obtaining long-term capital gain treatment with respect to the API.

Code §1061 applies to profits interests and specifically does not apply to capital interests or to returns on capital interests. It operates by applying Code §§1222(3) and (4) (i.e., defining long-term capital gain and loss treatment for the sale of capital assets held by more than one year) and substituting three years for one year. Code §1061 applies only with respect to APIs held by a taxpayer. In order to qualify as an API, the partnership interest must be, directly or indirectly, transferred to (or held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or a related person, in any applicable trade or business.

An applicable trade or business (ATB) is defined as an activity that is conducted on a regular, continuous, and substantial basis and which consists, in whole or in part, of (1) raising or returning capital, and (2) either (a) investing in or disposing of specified assets (or identifying such specified assets for investing or disposition), or (b) developing specified assets.

Excepted Partnership Interests

Exceptions exclude the treatment of certain partnership interests as APIs. An API does not include a partnership interest held by a corporation. Questions have arisen as to whether the reference to a corporation for these purposes might include an S corporation. The IRS has announced that S corporations are subject to the three-year holding period applicable to carried interests. See Notice 2018. In Notice 2018-18, the IRS stated that it will issue regulations that provide that the term “corporation” in Code §1061(c)(4)(A) does not include an S corporation. This will prevent taxpayers from using an S corporation to get around the three-year holding rule.

Capital Interest

An API does not include a capital interest which provides the partner with a right to share in partnership capital commensurate with (1) the amount of capital contributed (determined at the time of receipt of the partnership interest) or (2) the value of the interest included in income under Code §83 upon receipt or vesting. (The Conf. Rep. at 267 states: “in the case of a partner who holds a capital interest in the partnership with respect to capital he or she contributed to the partnership, if the partnership agreement provides that the partner's share of partnership capital is commensurate with the amount of capital he or she contributed (as of the time the partnership interest was received) compared to total partnership capital, the partnership interest is not an applicable partnership interest to that extent.” The Conf. Rep. at 266 also states that it is not intended that a partnership interest will fail to be treated as transferred in connection with the performance of services merely because a partner contributes capital. The IRS is directed to provide guidance implementing this intent. The two statements make it difficult to determine what amount of income associated with contributed capital will be exempt from §1061.)

Effective Date

The carried interest provisions are effective for taxable years beginning after Dec. 31, 2017. There is no grandfathering of API held as of the effective date of the Tax Act. Thus, the section applies to APIs acquired before the statute's effective date (Dec. 22, 2017).

Peter M. Fass is a partner at Proskauer Rose.