Keeping Treasury and the IRS busy writing guidance was not the point of the carried interest changes in the Tax Cuts and Jobs Act (P.L. 115-97), but it’s one immediate effect.
The addition of a three-year holding period for applicable partnership interests is not a sweeping change to the tax treatment of carried interest. However, it probably effectively diluted the political potency of demands to tax profits paid to investment managers that exceed their contributions to the partnership.
The problem with new section 1061 is not so much that it leaves open numerous opportunities for avoiding it — assuming that was Congress’s intention, which is its prerogative — but that it leaves many holes, including possibly unintended ones, for Treasury and the IRS to try to fill, as well as limited clues about how they can do that. Some holes will probably need a technical correction at a minimum. Writing tax statutes such that taxpayers can largely avoid their consequences is a curious legislative approach. So what was Congress’s purpose? The House explained in its report on the TCJA that the three-year holding period for some capital gains for holders of applicable partnership interests “strikes the right balance for economic growth and fairness without stifling investment” (H.R. Rep. No. 115-409, at 277). Look for more political disputes over whether the new rules appropriately struck that balance.
Section 1061 changes the asset holding period in section 1222 from one to three years for applicable partnership interests (APIs). If the holding period exceeds three years, the taxpayer gets long-term capital gain. If not, the taxpayer ends up with short-term capital gain. A special rule stipulates that guidance will specify when income or gain attributable to any asset is not held for portfolio investment on behalf of third-party investors. The idea behind this provision is to segregate the “enterprise value” — basically, the goodwill — of an investment management business and keep that out of section 1061. How to carve out enterprise value but also put in safeguards has been an issue in previous legislative proposals, which might be where Treasury and the IRS look first for ideas for guidance.
An API is a partnership interest that is, directly or indirectly, transferred to or held by the taxpayer in connection with the performance of substantial services by the taxpayer in any applicable trade or business. Applicable trades or businesses are activities that are regular, continuous, and substantial and that consist of raising or returning capital, and either investing in or disposing of specified assets or developing specified assets. Specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts regarding any of the previously listed assets, or an interest in a partnership to the extent of the partnership’s interest in the listed assets. The House report gives as an example of developing specified assets by representing to investors and others that the value, price, or yield of a portfolio business may be increased in connection with actions of a service provider or others acting with the service provider. But merely voting shares owned is not development.
There are two exceptions from API treatment. First, a partnership interest held directly or indirectly by a corporation is not an API. Notice 2018-18, 2018-12 IRB 443, informed taxpayers that S corporations will not be considered corporations for purposes of section 1061. The notice will be challenged. Attorney fees are the only potential downside for a plaintiff, and even legal representation should not be too expensive because it’s a straight question of law. Some partnerships have already converted to LLCs, so that may be the group from which the plaintiffs emerge. Another potential problem with the corporation exception is that carried interest can be held by a passive foreign investment company.
The second exception is that API doesn’t include a capital interest in the partnership that provides the taxpayer with a right to share in partnership capital commensurate with the amount of capital contributed or the value of the interest included in income under section 83 upon receipt or vesting. It’s unclear whether there is any limitation on the profit rights regarding an interest resulting from a contribution of capital to a partnership. The House report directs Treasury to provide guidance implementing Congress’s intent “that partnership interests shall not fail to be treated as transferred or held in connection with the performance of services merely because the taxpayer also made contributions to the partnership.” Taxpayers will need to tread carefully in figuring out how much income is associated with contributed capital, and thus is not subject to section 1061, until guidance comes out.
Steven M. Rosenthal of the Urban-Brookings Tax Policy Center said the problems with section 1061 start with the flawed approach of only reclassifying profits or gains from assets that have been held for less than three years. He said that because private equity funds typically hold assets for four to five years, the provision’s design fails to tax the purported target. “I think Congress needs to revisit this if they want to tackle carried interest effectively,” he said. In the meantime, Treasury and the IRS have a difficult job to do in drafting guidance, because the problems with the provision are structural, he said.
The new rule wasn’t in the TCJA for the revenue. New section 1061 opens plenty of planning opportunities, and indeed, there is a general expectation that hedge funds and private equity firms will use them. This expectation is reflected in the Joint Committee on Taxation score, which estimated that the new provision would raise $1.1 billion over the 10-year budget window (JCX-67-17). Compare that with the $15.6 billion that the significantly broader Carried Interest Fairness Act of 2015 from House Ways and Means Committee member Sander M. Levin, D-Mich., was projected to raise over 10 years, and the $3.1 billion over 10 years from the carried interest proposal in the Tax Reform Act of 2014 (JCS-1-14).
Changing the tax treatment of carried interest has never really been about the money, and it’s entirely possible that section 1061 sufficiently deflated the political arguments around it. Levin, who led the charge in 2007 and has since made multiple runs at carried interest legislation, isn’t pleased with the TCJA approach. He argued that increasing the amount of time that assets must be held to get long-term capital gains treatment is not a “real fix,” and Senate Minority Leader Charles E. Schumer, D-N.Y., is also trying to promote the idea that more should be done about carried interest. (Prior coverage: Tax Notes, Mar. 12, 2018, p. 1557.)
Republicans don’t seem terribly worried that voters will perceive section 1061 as an unfair loophole rather than a fulfillment of a campaign promise, and they’re probably right. From a technical perspective, much implementation work remains to be done regarding section 1061, but politically, the issue is probably settled for a while.
Coming Guidance
One clear aspect of the anticipated guidance is that gain with respect to the API applies both to a partner’s distributive share of partnership operations and to the gain or loss on a sale of an applicable partnership interest itself. Government officials at a May 11 session of the American Bar Association Section of Taxation meeting in Washington agreed that “with respect to” includes both situations.
How to handle the other questions that guidance will need to address is much less clear. The main issue is that not all long-term capital gain provisions reference section 1222. For example, guidance might need to clarify whether section 1061 also recharacterizes section 1231 gain. The holding period for section 1231 gain is not in section 1222. It seems that it should be, but it’s unclear whether Treasury has the authority to write that rule. It is also possible that the omission was a drafting error that Congress will correct. If section 1231 assets are omitted from the application of section 1061, real estate funds generally will be unaffected because they tend not to have capital assets, Rosenthal said. Section 1256 gain similarly seems unaffected by section 1061 under the terms of the statute.
There is a special rule in section 1061 regarding transfers of an API to a related party, but it’s hardly a model of clarity either. Section 1061(d) provides 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) seems to have been borrowed from the Tax Reform Act of 2014, but there it was used in the context of a recharacterization account balance, which isn’t in section 1061. The House report may offer a limited explanation of the purpose of the related-party rule in its admonition that Treasury should exercise its regulatory authority to prevent “abuse of the purposes of the provision, including through the allocation of income to tax-indifferent parties.” Additional guidance will also address the application of section 1061 to tiered structures, in accordance with the House report.