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ABA Says Carried Interest Rules Should Be Modified, Not Repealed

JUN. 25, 2021

ABA Says Carried Interest Rules Should Be Modified, Not Repealed

DATED JUN. 25, 2021
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June 25, 2021

The Honorable Ron Wyden
Chairman
Senate Committee on Finance
219 Dirksen Senate Building
Washington, DC 20510

The Honorable Richard Neal
Chairman
House Committee on Ways and Means
1102 Longworth House Building
Washington, DC 20515

The Honorable Mike Crapo
Ranking Member
Senate Committee on Finance
219 Dirksen Senate Building
Washington, DC 20510

The Honorable Kevin Brady
Ranking Member
House Committee on Ways and Means
1139 Longworth House Building
Washington, DC 20515

Re: Legislation to Repeal Code Section 1061, Partnership Interests Held in Connection with Performance of Services

Dear Chairmen Neal and Wyden and Ranking Members Crapo and Brady:

We understand that Congress is considering legislation to repeal section 1061 of the Internal Revenue Code1 and replace it with a new provision regarding the tax treatment of partnership interests held in connection with the performance of services.2 As detailed below, we recommend that Congress not repeal section 1061 and instead amend it as might be appropriate to achieve the desired policy objectives.

The views expressed herein are presented on behalf of the American Bar Association Section of Taxation (the “Section ”). They have not been approved by the House of Delegates or Board of Governors of the American Bar Association and, accordingly, should not be construed as representing the position of the American Bar Association.3 This letter is not intended to express the views of the Section or of any individual regarding the policy goals Congress may be considering. Rather, if Congress determines that certain compensatory partnership interests should be taxed at short-term capital gains (or ordinary income) tax rates, this letter briefly explains the Section's views on methods for achieving that result.

Section 1061, which was added to the Code by the 2017 tax act (the “2017 Act”),4 generally requires a partnership (or other entity classified as a partnership) to hold capital assets for more than three years in order for the related capital gains allocated to holders of certain compensatory interests in the partnership, including carried interests, to be taxed at preferential long-term capital gain rates. Before the enactment of section 1061, multiple bills had been introduced in previous Congresses to modify the treatment of carried interests.5 Some of these bills recharacterized capital gain into ordinary income or imputed ordinary income to the taxpayer. The Section commented on certain of these bills, pointing out the significant complexity of many of those legislative proposals, resulting largely from their use of certain concepts requiring additional guidance and their inconsistency with some of the basic principles of subchapter K of the Code, among other things.6 Ultimately, no relevant legislation became law until section 1061 was added to the Code. Since then, proposed Treasury regulations implementing section 1061 were issued in 2020,7 followed by final Treasury regulations in 2021.8

In general, section 1061 and the associated Treasury regulations represent significant steps towards taxing partnership interests, including carried interests, that are compensatory in nature more like other forms of compensation. Nevertheless, various commentators have identified multiple ways in which section 1061 could be revised to better achieve that policy objective or broaden the scope of section 1061. For example, in its comments on the proposed Treasury regulations dated October 5, 2020,9 the Section recommended, among other things, that a clarification be sought providing that carried interests held by S corporations are subject to section 1061.10 The New York State Bar Association Tax Section proposed that section 1231 gains on property used in a trade or business be made subject to section 1061.11 Other commentators have focused on revisions to the three-year holding period requirement. For example, some have suggested lengthening the holding period, or applying it uniformly to both the holding period in the underlying assets of the partnership and the holding period in the partnership interest itself.12

We strongly believe that section 1061 provides a solid statutory and regulatory framework to address the taxation of compensatory partnership interests, including any additional revisions Congress believes are necessary. To the extent Congress believes that section 1061 in its current form does not adequately achieve various policy objectives, we recommend that Congress amend — i.e., build on — section 1061. We believe this can be done without fundamental changes to section 1061, and that, by preserving section 1061 rather than starting afresh, it can be done with fewer delays and disruptions. We note that the Department of the Treasury (the “Treasury”) and the Internal Revenue Service (the “Service”), as well as taxpayers, have been working with section 1061 for more than three years, and that, as discussed above, detailed regulations already have been promulgated to implement the provision — in many cases addressing issues that would have to be addressed again under any new legislation. We believe that repealing section 1061 and enacting an entirely new framework to address the same policy objectives would be less efficient and require more time and resources for Congress, Treasury, the Service, and taxpayers than working within the existing framework to implement any desired changes.13

Finally, we note that the Greenbook recently released by the Biden Administration14 proposes to repeal section 1061 for partners whose taxable income (from all sources) exceeds $400,000. Specifically, the proposal would tax as ordinary income a partner's share of income on an “investment services partnership interest” in an investment partnership, regardless of the character of the income at the partnership level, if the partner's taxable income (from all sources) exceeds $400,000. Partners whose taxable income does not exceed $400,000, on the other hand, still would be subject to section 1061. We believe this sort of dual regime would add significant complexity to the tax law by creating two different sets of rules that would apply differently to different partners in the same partnership (or, with its cliff effect at $400,000 of taxable income, to the same partner in different tax years).15

The Biden Administration proposal also would require partners subject to the new rule to pay self-employment taxes on their share of income. Consistent with our discussion above, we believe this could be done just as easily by amending section 1061 with the same revenue impact.

In sum, we believe section 1061 provides a logical and robust infrastructure to accommodate future changes with respect to the taxation of compensatory partnership equity, including the taxation of carried interests. Retaining and amending section 1061 would avoid the issues and complexity of enacting a new provision to address the same policy concerns.

We appreciate your consideration of this letter. Representatives of the Section would be pleased to discuss this letter with you or your staffs. Please contact me at (215) 981-4362 or joan.arnold@troutman.com, or Kurt Lawson, Vice Chair (Government Relations), at (202) 637-5660 or kurt.lawson@hoganlovells.com, to arrange a call or meeting.

Sincerely,

Joan C. Arnold
Chair, Section of Taxation
American Bar Association
Washington, DC

cc:
Mark Mazur, Acting Assistant Secretary (Tax Policy) and Deputy Assistant Secretary (Tax Policy), Department of the Treasury
Kimberly A. Clausing, Deputy Assistant Secretary for Tax Analysis, Department of the Treasury
Aruna Kalyanan, Deputy Assistant Secretary for Tax and Budget, Office of Legislative Affairs, Department of the Treasury
Thomas West, Deputy Assistant Secretary, Domestic Business Tax, Department of the Treasury
Krishna P. Vallabhaneni, Tax Legislative Counsel, Department of the Treasury
Roger Pillow, Senior Counsel, Department of the Treasury
Hon. Charles P. Rettig, Commissioner, Internal Revenue Service
William M. Paul, Acting Chief Counsel, Internal Revenue Service
Holly Porter, Associate Chief Counsel (Passthroughs & Special Industries), Internal Revenue Service
Thomas Moffitt, Deputy Associate Chief Counsel (Passthroughs & Special Industries), Internal Revenue Service
Kara K. Altman, Attorney, Office of Chief Counsel (Passthroughs & Special Industries), Internal Revenue Service
Sonia K. Kothari, Attorney, Office of Chief Counsel (Passthroughs & Special Industries), Internal Revenue Service

FOOTNOTES

1Unless indicated otherwise, all “section” references are to the Internal Revenue Code of 1986, as amended (the “Code”), and all “Treas. Reg. §” references are to the Treasury regulations promulgated under the Code, in each case as in effect as of the date of this letter.

2See, e.g., H.R. 1068, 117th Cong. (Feb. 15, 2021) (recently proposed legislation treating as ordinary income, regardless of the holding period, the net capital gain with respect to an investment services partnership interest except to the extent such gain is attributable to a partner's qualified capital interest).

3Principal responsibility for drafting this letter was exercised by Jennifer Sabin, Eric Sloan, and Pamela Lawrence Endreny. Substantial contributions were made by Benjamin Applestein and Eric Solomon. This letter has been reviewed by Beverly Katz and Lisa Zarlenga of the Committee on Government Submissions, and Kurt Lawson, Vice Chair for Government Relations for the Section. Although members of the Section may have clients who might be affected by the federal tax principles addressed by this letter, no member who has been engaged by a client (or who is a member of a firm or other organization that has been engaged by a client) to make a government submission with respect to, or otherwise to influence the development or outcome of one or more specific issues addressed by, this letter has participated in the preparation of the portion (or portions) of this letter addressing those issues. Additionally, while the Section's diverse membership includes government officials, no such official was involved in any part of the drafting or review of this letter.

4Pub. L. No. 115-97, 131 Stat. 2054 (2017). The formal title of the 2017 Act is “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” but it often is referred to as the “Tax Cuts and Jobs Act” or the “TCJA.”

5See H.R. 2834, 110th Cong. (2007); H.R. 6275, 110th Cong. (2008); H.R. 1935, 111th Cong. (2009); H.R. 4016, 112th Cong. (2012); S. 268, 113th Cong. (2013); H.R. 1, 113th Cong. (2014); H.R. 2889, 114th Cong. (2015); S. 1686, 114th Cong. (2015); S. 781, 116th Cong. (2019); H.R. 1735, 116th Cong. (2019); S. 1639, 116th Cong. (2019).

6See, e.g., ABA Section of Taxation, Update of ABA Section of Taxation Comments on H.R. 2834 with respect to H.R. 4213 (2010), available at: https://www.americanbar.org/content/dam/aba/administrative/taxation/migrated/pubpolicy/2010/051110commentsHR4213.pdf; ABA Section of Taxation, Update of ABA Section of Taxation Comments on H.R. 2834 with respect to H.R. 4213 (2010), available at: https://www.americanbar.org/content/dam/aba/administrative/taxation/migrated/pubpolicy/2010/051110commentsHR4213.pdf; ABA Section of Taxation, Comments on Carried Interest Proposals in Senate Amendment 4386 to H.R. 4213 (2010), available at: https://www.americanbar.org/content/dam/aba/administrative/taxation/migrated/pubpolicy/2010/110510comments.pdf; see also New York State Bar Association Tax Section, Report on Proposed Carried Interest and Fee Deferral Legislation (2008), available at: https://nysba.org/app/uploads/2020/03/1166-Report.pdf.

785 Fed. Reg. 49,754 (Aug. 14, 2020).

886 Fed. Reg. 5,452 (Jan. 19, 2021).

9ABA Section of Taxation, “Comments on Applicable Partnership Interests under Section 1061” (2020), available at: https://www.americanbar.org/content/dam/aba/administrative/taxation/policy/2020/100520comments.pdf; see also New York State Bar Association Tax Section, “Report on Proposed Regulations Under Section 1061,” (2020), available at: https://nysba.org/app/uploads/2020/10/Report-1442.pdf.

10The Treasury regulations take this position already, see Treas. Reg. § 1.1061-3(b)(2), although the statute itself is unclear. As the Section previously explained, there still is the potential for avoidance of section 1061 through the acquisition of partnership interests by S corporations for taxpayers who may take the position that the regulation is invalid due to the lack of a broad enough grant of regulatory authority in the statute.

11New York State Bar Association Tax Section, “Report on Proposed Regulations Under Section 1061,” (2020), available at: https://nysba.org/app/uploads/2020/10/Report-1442.pdf. The final Treasury regulations did not, however, adopt this suggestion. See 86 Fed. Reg. at 5,470.

12The Treasury regulations do this to a large extent already, see Treas. Reg. § 1.1061-4(b)(8), although the statute itself is unclear.

13We also note the importance to ensuring the successful implementation of any new tax provision — especially one in an area as complex as subchapter K — of providing adequate funds to the Service to train its personnel and carry out enforcement initiatives, all of which the Section has long supported.

14General Explanations of the Administration's Fiscal Year 2022 Revenue Proposals, available at https://home.treasury.gov/system/files/131/General-Explanations-FY2022.pdf.

15We believe this dual regime would also add a significant compliance burden, as partners allocated less than $400,000 of taxable income might, when combined with their other sources of taxable income, have taxable income in excess of the $400,000 threshold. Thus, an investment partnership would need to provide information sufficient to allow the partners to comply with both regimes.

END FOOTNOTES

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