The new tax cut and Jobs Act adds section 1061 to the Code, addressing the taxation of “applicable partnership interests.” Under the provision, if one or more “applicable partnership interests” were held by a taxpayer at any time during the tax year, some portion of the taxpayer’s long-term capital gain with respect to those interests may be treated as short term capital gain if the holding period is less than three years. Under the Cut law, partnership provisions requires holding period must be greater than three years.
New Tax Code section 1061 applies only with respect to “applicable partnership interests.” To qualify as such, the partnership interest has to be 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 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. Specified assets” include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to the forgoing assets, or an interest in a partnership to the extent of the partnership’s interest in the forgoing assets.
Two exceptions may apply to exclude treatment of certain partnership interests as applicable partnership interests. First, an applicable partnership interest does not include a partnership interest held by a corporation. Second, an applicable partnership interest does not include a capital interest that 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 section 83 upon receipt or vesting. This exception appears intended to allow a service partner to earn income as long-term capital gain under the normal rules with respect to a partnership interest received in exchange for contributed capital or to the extent the partner included the value of the interest in income under section 83.
The three-year holding period in section 1061does not apply to income or gain attributable to any asset not held for portfolio investment on behalf of “third-party investors.” A third-party investor for this purpose is a person who– (1) holds an interest in the partnership that is not held in connection with an applicable trade or business; and (2) is not and has not been actively engaged (and is not and was not related to a person so engaged) in (directly or indirectly) providing substantial services related to an applicable trade or business to the partnership or any applicable trade or business. This provision appears to be aimed at the “enterprise value” issue and seems to direct the Secretary to promulgate regulations that exclude gain from the intangible asset value associated with a sponsor’s investment management business from the application of the new rules.
New Code section 1061 would provide that, upon the transfer of an applicable partnership interest to a related person, the transferor must include short-term capital gain equal to the excess of – (1) the taxpayer’s long-term capital gain with respect to such interest for such tax year attributable to the sale or exchange of any asset held for not more than three years as is allocable to such interest; over (2) any amount already treated as short term capital gain under the primary provision with respect to the transfer of such interest.
For this purpose, a related person includes only persons with a family relationship under section 318(a)(1) and persons who performed services in the current calendar year or the prior three calendar years in any applicable trade or business in which or for which the taxpayer performed any service. This provision appears to be aimed at assignment of income issues, although the provision is drafted in a manner that makes it difficult to determine its exact effect.
The new law provides that short-term capital gain treatment applies under section 1061 “notwithstanding section 83 or any election in effect under section 83(b).”New section 1061 provides authority for the issuance of such regulations or other guidance as are necessary to carry out the purposes of the provision. The provisions covered by the amendment are effective for tax years beginning after December 31, 2017.
The new law does not include rules “grandfathering” applicable partnership interests held as of the effective date of such legislation. The three-year holding period described in the would be required for sales of assets held (directly or indirectly) by the applicable partnership, or, in the case of the sale of an applicable partnership interest, the applicable partnership interest itself. Rather than treating amounts failing the three-year test as ordinary income (as has been the typical recharacterization under prior versions of proposed carried interest legislation), section 1061 treats such gain as short-term capital gain.
Significantly, the new section operates only by modifying the application of sections 1222(3) and (4) and requiring a holding period for “capital assets” of more than three years in order to recognize long-term capital gain or loss. The Code contains a number of other provisions, such as section 1231, which result in taxation of gain recognized at long-term capital gain rates without reference to section 1222. The new section appears not to impact the application of those provisions, even with respect to assets held for three years or less.
The new law resolves this controversy by simply excluding corporations that hold partnership interests from the new rules.
Questions have arisen as to whether the reference to a “corporation” for these purposes includes an S corporation. On March 1, 2018, the Internal Revenue Service issued Notice 2018-18, which provides that for purposes of Code Section 1061, the exception for interests held by corporations only applies to C corporations and does not apply to S corporations preventing the three-year holding period from being avoided by holding a carried interest through an S corporation). An entity which has elected to be treated as an S corporation, regardless of whether such entity is a state-law corporation, limited liability company, trust or other, will not qualify for the exception to the three-year hold rule.
If a partner contributes capital to a partnership, then so long as the partnership agreement provides that the partner’s share of partnership capital is commensurate with the amount of capital that 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 explanatory statement also indicates that it is not intended that a partnership interest would fail to be treated as transferred in connection with the performance of services merely because a partner contribute capital , The explanatory statement attempts to clarify the statutory language by providing that short-term capital gain treatment will result “notwithstanding section 83 or any election in effect under section 83(b).” According to the explanatory statement, the fact that a taxpayer has included an amount in income under section 83 upon the acquisition of an applicable partnership interest or has made an election under section 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 applicable partnership interest.
» Michael Prestia practices in Patnership formation, tax member disputes in Gulfport.
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