This past Friday, the IRS and the Treasury Department released the proposed carried interest regulations. The carried interest provision, which was added to the Code by TCJA, recharacterizes certain net long-term capital gains of a partner that holds one or more applicable partnership interests as short-term capital gains. The following is a high-level summary of the key points of the proposed regulations. 

Background

In general, gain from the sale or exchange of a capital asset held for more than one year is treated as long-term capital gain.  Individual taxpayers get a favorable tax rate on long-term capital gains, a 20 percent rate on capital gain as compared to a top marginal tax rate of 37 percent on ordinary income.  The TCJA enacted Section 1061 which imposes a three-year holding period (not the generally applicable one-year holding period) in the case of long-term capital gain attributable to applicable partnership interests (“APIs”). Gain attributable to an API can include a distributive share of gain or loss from the sale of underlying assets held by the partnership or gain or loss from the sale of the API itself (“API Gains and Losses”).  If the holder of an API recognizes a difference between API Gains or Losses attributable to assets that satisfy the three-year holding period and those that do not, such difference is treated as short-term capital gain or loss and is subject to tax at the rates applicable to ordinary income (the “Recharacterization Amount”).

APIs

In general, an API is a partnership interest held by or transferred to, a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or by any other related person, in any applicable trade or business (“ATB”). However, an API does not include:

• An interest held by a person who is employed by another entity that is not conducting an ATB and provides services only to such other entity.
• Any partnership interest that is held directly or indirectly by a C corporation (excluding a PFIC with respect to which a shareholder has a QEF election in effect).  
• Certain capital interests in the partnership (“Capital Interest Gains and Losses”)[1].  
• Certain partnership interests that would be treated as an API but are bought by unrelated purchasers that are not service providers to the ATB.

ATB

For this purpose, an ATB includes any activity conducted on a regular, continuous, and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of:

• Raising or returning capital (“Raising or Returning Capital Actions”), and 
• Either (A) investing in (or disposing of) certain assets (the “Specified Assets”) or identifying Specified Assets for such investing or disposition (“Investing Actions”), or (ii) developing Specified Assets (the “Developing Actions”).  

Unfortunately, the determination of whether the performance of services was in an ATB is not necessarily straightforward:

• The Raising or Returning Capital Actions and the Investing Actions or Developing Actions do not need to occur in the same year to constitute an ATB.
• The aggregate actions conducted by the taxpayer and its related persons with respect to Raising or Returning Capital Actions and Investing or Developing Actions are considered in determining the existence of an ATB.
• Actions taken to manage working capital (e.g., holding cash in a business that does not otherwise hold Specified Assets) are not be considered.
• The actions of a lower-tier partnership impact whether an upper-tier partnership has an ATB.

A&M Insight: In general, once a partnership interest is characterized as an API, it continues to be an API, even if the taxpayer ceases to provide services or engage in an ATB. Therefore, correctly characterizing a partnership interest at the outset is of the utmost importance. A&M is available to discuss your situation to determine whether a partnership interest should be characterized as an API.

Substantial Services

The proposed regulations provide that if a taxpayer provides any services in an ATB and an allocation of a partnership’s profits is transferred to or held by the taxpayer in connection with those services, then there is a presumption that the services are substantial services.  The regulations seek comments as to factors that should be considered to rebut the presumption, but currently, the proposed regulations do not contain any that could be used.

Determination of API Gains and Losses

If a taxpayer has an API, then it must determine its API Gains and Losses for the taxable year.  For this purpose, an API Gain or Loss is generally any gain or loss that is allocated to the taxpayer with respect to its API, including gains from installment sales that occurred prior to, but are included in income after, the effective date of section 1061.  However, the proposed regulations do exclude the following from API Gains and Losses:

• Certain gains or losses from the sale or exchange of assets that were held for more than three years as of January 1, 2018 (“Transition Amounts”).
• Certain gains and income (e.g., gain determined under sections 1231 and 1256 and qualified dividends).

Determination of the Recharacterization Amount

For purposes of determining whether a gain or loss is factored into the Recharacterization Amount, the holding period of the owner of the asset controls (e.g., the holding period of the API is relevant if the interest is sold or the holding period of the underlying assets of the partnership is relevant if the sale occurs at that level). Solely for purposes of determining the Recharacterization Amount, if the owner holds multiple interests in the partnership (e.g., a capital interest and an API), the holding period of the combined interest is bifurcated based on the FMV on the date the interest is disposed of (as opposed to the date of issuance).

A&M Insight: For a partner that holds an API that is looking to exit the partnership, the application of the proposed regulations could vary if there is disconformity between the inside and outside holding period.

Additionally, the proposed regulations adopt a hybrid approach with respect to tiered pass-through entities.  In essence, API Gains and Losses which are attributable to one or more APIs held indirectly (through one or more partnerships, S corporations or PFICs with respect to which a shareholder has a QEF election in effect (“Passthrough Entities)) flow through the tiers and retain their character as API Gains and Losses. Such amounts are then netted at the ultimate taxpayer level to determine the Recharacterization Amount. 

Anti-abuse Rules

The proposed regulations include several anti-avoidance rules, including:

• Treating long-term capital gain or loss on the disposition of a capital asset that was distributed from a partnership with respect to an API as API Gain or Loss if the asset is held for more than one year but not more than three years (inclusive of the partnership’s holding period) at the time the distributee-partner disposes of the property.
• Accelerating the recognition of short-term capital gain attributable to an API (based on a hypothetical sale of the assets held for less than three years) upon a direct or indirect transfer to a related party (excluding a transfer to a partnership in exchange for a partnership interest) that does not otherwise constitute a taxable event for U.S. federal income tax purposes.
• Ignoring a portion of the holding period of the API if the API interest is sold and 80% or more of the underlying assets do not satisfy the three-year holding period. 
• Requiring securities partnerships to take the carried interest rules into account when determining the aggregation of gains and losses from financial assets in order to be a reasonable method.

Proposed Applicability Date of Final Regulations

The proposed regulations are generally applicable for taxable years beginning on or after the date final regulations are published in the Federal Register. With the exception of the rules regarding Transition Amounts, taxpayers may retroactively rely on the proposed regulations, provided they follow the proposed regulations in their entirety and in a consistent manner. In contrast, taxpayers may rely on the Transition Amounts rules for taxable years beginning in 2020 and subsequent taxable years, without having to consistently follow all of the rules provided in the proposed regulations.

A&M Taxand Says

While the passage of the carried interest provision as part of TCJA was inconvenient for fund managers, it is important to note that the proposed regulations could have been much stricter and impacted many more situations than they currently do. This can be easily evidenced by the delayed applicability date, as opposed to a retroactive date as some had anticipated, at least partially applying. Additionally, in determining the Recharacterization Amount, the focus is on the asset sold. As a result, the tax consequences in an exit scenario (i.e., the sale of all of the partnership’s assets or the sale of the interest in the partnership) may be materially different. This is particularly relevant in cases where section 1231 assets represent a significant portion of the inherent appreciation.  With that said, funds and their managers, should examine their current structure and the potential application of the proposed carried interest regulations. A&M is happy to discuss the implications of the regulations, as well as evaluate potential structural alternatives to address the economic deal.

[1] The proposed regulations provide detailed rules regarding the extent an interest is treated as a capital interest for this purpose, including the computation of Capital Interest Gains and Losses (which expands on the existing rules on revaluations under the Section 704(b) regulations) so that API Gains and Losses are not converted to Capital Interest Gains and Losses. Additionally, amounts loaned to a partner to fund a capital contribution are excluded from the definition of invested capital (although a repayment of those loans is treated as invested capital).