When Congress enacted the Tax Cuts and Jobs Act of 2017, it included what was billed as a capstone to an almost decade-long debate about how to tax the income earned by general partners in private investment funds. The discussion — unusually for tax questions — had erupted onto the national stage and was even brought up in debates between the 2016 presidential candidates.
Section 1061 is meant to change the taxation of carried interest by changing the asset holding period in section 1222 from one to three years for applicable partnership interests (APIs). An API is a partnership interest that a taxpayer transfers in connection with the performance of substantial services in an investment-type business. If the taxpayer’s holding period exceeds three years, the taxpayer gets long-term capital gain. If not, the taxpayer has short-term capital gain. Long-term capital gain is taxed at a lower rate.
There are numerous questions raised by section 1061. (Prior analysis: Tax Notes, Apr. 8, 2019, p. 192, and Tax Notes, Jun. 18, 2018, p. 1707.) One of the most curious is what to make of subsection 1061(d). That rule says that if a taxpayer transfers an API to a related party, the taxpayer has short-term capital gain equal to the excess of the taxpayer’s long-term capital gain regarding the interest for the tax year attributable to the sale or exchange of any asset held for less than three years as is allocable to the interest over any amount treated as short-term capital gain under section 1061(a) regarding the transfer of the interest. Related parties are individuals with a family relationship and persons who performed a service in the current calendar year or the preceding three calendar years in any applicable trade or business in which or for which the taxpayer performed a service.
The language of section 1061(d) was cribbed from former Rep. Dave Camp’s comprehensive tax reform proposal, the Tax Reform Act of 2014, but Camp’s carried interest proposal had different mechanics, and there isn’t a clear connection between what the related-party rule was intended to accomplish in TRA 2014 and its purpose here. The TRA 2014 version required a taxpayer to include his recharacterization account balance in gross income if he transferred his interest to a related party. The recharacterization account balance was a defined term in the TRA. When the subsection was imported into the TCJA, the recharacterization account balance concept was stripped out, and now it’s unclear how to determine the amount described in section 1061(d)(1)(A). It’s also unclear what Congress was trying to achieve with the current iteration, and there is no legislative history to help pin down a concrete purpose that can be implemented in regulations. The provision seems to be directed at assignment of income issues, but the problem Congress was trying to address is not obvious.
Practitioners say that subsection (d) could have been intended to either address nontaxable transfers to a related party, such as gifts, or create a look-through rule for taxable transfers to related parties. But those purposes aren’t consistent with each other, so Treasury — or, better yet, Congress — should step in and clarify what the statute means. Subsection (d) provides an object lesson in the importance of careful legislative drafting: When borrowing the ideas and language from prior bills, taxwriters should be cautious about what they’re adopting.