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Business and International Tax Developments

Understanding the New Carried Interest Characterization of Income Rules

A profits interest issued by a partnership to a service provider has been the subject of a long-standing debate by the Internal Revenue Service and taxpayers receiving such profits interest. The Service has, in general, viewed such interests that are issued in exchange for services to be “property” that is subject to current taxation under section 61(a) to the extent of the fair market value of the interest received. The Service was challenged with respect to its position on the basis that the value of the profits interest on grant was indeterminable or on the basis that the interest was not “property” under a section 83 type of approach where the profits interest was forfeitable and non-transferable. The scorecard of the reported cases in this area reflects that there were more taxpayer victories than defeats but victory did not come by accident but through careful advance planning.

Where a service provider is issued a capital interest in a partnership for services the tax outcome is clear, i.e., the service provider is in receipt of taxable income.[1] While there is a degree of ambiguity as to the definition of a “capital” interest, it is easily identifiable where a service provider’s receipt of an interest in the partnership results in a reduction of the other partners’ capital contributions to the partnership. In other words, a capital interest is relinquished to the extent to which any partner in the partnership’s right to receive a distribution from his withdrawal from, or liquidation of, the partnership is reduced. [2]

The Internal Revenue Service announced a safe harbor rule for insulating the recipient of a profits interest from immediate taxation by issuing Rev. Proc. 93-27, 1993-2 CB 343.[3] The procedure started with a statement of what is a capital interest.

“A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.”

Accordingly, if the receipt of an interest in a partnership is not a “capital interest”, then for purposes of Rev. Proc. 93-27, supra, it was eligible to be treated as the non-taxable receipt of a “profits interest”. In such event, the receipt of such profits interest for services is not taxable to the service provider so long as the person receives that interest either as a partner or in anticipation of becoming one.

Section 2.01 of the pronouncement defines a “capital interest” as an interest that would allow the holder to receive a share of the proceeds were the partnership’s assets sold at fair market value and then distributed in complete liquidation.  However, the newly announced safe harbor did not apply where: (i) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or high-quality net lease; or (ii) the partner disposes of the profits interest within two years of receipt; or (iii) the profits interest is a limited partnership interest in a publicly traded partnership per section 7704. The determination of whether an interest is a profits interest versus a capital interest was to be made at the time of the receipt of the partnership interest.

The 1993 revenue procedure was superseded by Rev. Proc. 2001-43, 2001-2 CB 19. The Service wanted to clarify its earlier pronouncement by providing guidance on the treatment of the grant of a partnership profits interest that is substantially non-vested within the meaning of Treas. Reg. §1.83-3(b). Rev. Proc. 2001-43, supra, restated that whether an interest is a profits interest or not is tested at the time the interest is granted even if at such time the interest is substantially nonvested. The Service further stated that it will not treat the grant of the interest or an event that causes the interest to become substantially vested under section 83 regulations as a taxable event for the partner or the partnership. [4] The revised safe harbor added a requirement that the partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant and the service provider takes into account the distributive share of partnership income, gain, loss, deduction, and credit associated with that interest in computing the service provider's income tax liability for the entire period during which the service provider has the interest.

While tax practitioners and their clients were able to live with the safe harbor rules in structuring hedge fund, private equity fund managers and real estate developers with the ability to realize long-term capital gains on sell-out events in which the anticipated profits would be substantially realized, the resulting disproportionality of long-term capital gain, i.e., the so-called “20% leg” to the smaller “2% leg” taxed as ordinary income throughout the term of the fund, drew increasing criticism from certain members of Congress as well as highly-regarded members of the academic community. After all, wasn’t the “20% leg” still received for services?[5]

            The Compromise on Carried or Profits Interest Reflected in the New Law

Section 13309 of the Tax Cuts and Jobs Act, P.L. 115-97, enacted into law section 1061 which applies to partnership interests held in connection with the performance of services. Section 1061 requires an asset holding period of greater than three years with respect to an “applicable partnership interest” in order to obtain long-term capital gain treatment. This assumes, of course, that the applicable retained interest commenced its holding period as the result of a prior identifiable event.

The three-year holding period is required for sales of assets held (directly or indirectly) by the applicable partnership. Presumably, the three-year holding period also applies to the sale of the applicable partnership interest itself.[6] For example, where a partnership sells an asset held for more than three years, gain allocated to a partner who has held a partnership interest (for services) for less than three years may still realize long-term capital gain.[7] Subject to the related party sale rule in section (d),  if a service partner sells its interest, as long as that partner has a holding period for its entire partnership interest for longer than three years, then long-term capital gain may be recognized subject to section 751(a) or similar provision.[8]

In determining the holding period of an asset, a taxpayer should apply the same rules that govern application of the one-year standard under section 1222.  With respect to interests in a partnership, a new holding period can commence with respect to each separate contribution made to, or each purchase of an interest in a partnership.[9] The regulations allow for netting of contributions and distributions within a one-year period when determining the holding period of a partnership interest.[10]

Section 1061 recharacterizes applicable gain as short-term capital gain and not as ordinary income as had been suggested in prior versions of the carried interest reform proposals.[11] Short-term capital gain is taxed at ordinary rates.  However, the statutory rule mandating short-term capital gain has other impacts. For example, as short-term capital gain and despite its nexus to services rendered, etc., section 1061 income should not be treated as income from self employment under section 1401. It could, however, be within the reach of section 1411, 3.8% tax on net investment income, unless a pertinent exception applies.  

Section 1061 imposes the short-term capital gain (or loss) characterization treatment regardless of whether the service recipient made a section 83(b) election. It would be fair to assume that the making of a section 83(b) election will start the three year holding period. As drafted, section 1061 leads to some surprising outcomes regarding gain that seemingly is, and is not, subject to recharacterization under the three-year holding period rule.

Section 1061(a)(2) substitutes a three year holding period for one year for long term capital gains described in section 1222(3) and losses under section 1222(4). An unanswered question is how does the three year rule apply, if at all, to gains or losses recognized under section 1231 with respect to property used in a trade or business and involuntary conversions. If long-term capital gains are recognized under section 1231 under an imputed three year period rationale instead of the one year rule, does that mean that net losses under section 1231 carry a three year holding period as well? This last outcome may not appear to make much sense. This area, i.e., the application of section 1231 and similar provisions, is in need for immediate guidance and perhaps some re-thinking by Congress.

            Defining Applicable Partnership Interests

 Section 1061(c) defines the term “applicable partnership interest.” In general, an “applicable partnership interest” is any interest in a partnership, which directly or indirectly, is transferred to the taxpayer in consideration for the performance of “substantial services” by the taxpayer or any other related person, provided that such services be rendered in any “applicable trade or business”. Under section 1061(c)(4), an applicable partnership interest does not include: (1) any interest in a partnership directly or indirectly held by a corporation; or (2) any capital interest in the partnership which provides the taxpayer with a right to share in partnership capital based on the amount of capital contributed (at the time of the receipt of such partnership interest) or the value of such interest is subject to tax under section 83 either upon receipt or upon vesting.

Under section 1061(c)(2) an “applicable trade or business” means any activity conducted on a regular, continuous, and substantial basis,[12] which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part of: (A) “raising or returning capital” and (B) either (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition), or (ii) developing specified assets.

Section 1061(c)(3) defines “specified asset” by cross-reference to the definition of a “security” in section 475(c)(2) but without regard to the last sentence, commodities defined in section 475(e)(2), real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing and an interest in a partnership to the extent of the partnership’s pro rata share in any of  the forgoing assets.  The definition of what is and what is not an applicable partnership interest deserves much attention and thought in issuing regulations.

As mentioned, section 1061(c)(1) provides that the general rule defining an applicable partnership interest “shall not apply to an interest held by a person who is employed by another entity that is conducting a trade or business (other than an applicable trade or business) and only provides services to such other entity.” This rule would presumably treat employees of private equity portfolio companies who receive an interest based on their services to the company as not receiving an applicable partnership interest. The rationale would be that the services rendered are not with respect to an “applicable trade or business” since the business does not hold specified assets. But what if the entity held some securities or held a capital interest in the fund? What then?

Definitional issues and problems will arise with respect to real estate activities. Hopefully the regulations when issue will broadly define the scope of active real estate projects not involving “real estate held for rental or investment”. What if, for example, a carried interest is issued for services to manage a mall where substantial services are provided to tenants within the mall but outparcels of the same tract are triple-net-lease arrangements. Would such limited arrangements result in a “specified asset? Would “held for rental” include any and all properties held for “rental” even one year rentals in a rental community of 100 or more units in a project that offers substantial amenities, food and other services?

The new law excludes “corporations” from being subject to section 1061. This is set out in section 1061(c)(4)(A). Does “corporation” include an S corporation or an LLC that makes a reverse default election to be taxed as an association”?  On March 1, 2018, the Treasury and IRS issued Notice 2018-18, 2018-12 IRB 443 that for purposes of section 1061(c)(4)(A), “corporation” does not include an S corporation.  There is little in the way of Congressional history to support this position. Perhaps the Notice simply plugs the “hole in the dam” until technical corrections legislation amends the statute. [13]

            Related Party Rule

Section 1061(d) provides that where a taxpayer transfers an applicable partnership interest to a related person, the transferor must include in short-term capital gain the excess of:

(A) so much of the taxpayer’s long-term capital gains with respect to such interest for such taxable year attributable to the sale or exchange of any asset held for not more than 3 years as is allocable to such interest, over (B) any amount treated as short term capital gain under  under section 1016(a) with respect to the transfer of such interest. For purposes of this rule, a related person includes only persons with a family relationship under section 318(a)(1) and persons who performed services during the current calendar year or the prior three calendar years in any applicable trade or business in which or for which the taxpayer performed a service.  Will this rule be applied to the estate or trust of the service provider? What if the transfer involves the sale to a “defective” family trust?

This post only provides the framework for section 1061 which reflects a “patch-quilt” like approach to resolving an issue in the income tax law that was in need of a solution and what we have to ponder is a whole new set of questions. Much guidance is needed. What would be helpful of course is for the regulations to acknowledge that the existing safe harbor revenue procedures remain in place and that section 1061 does not provide nonrecognition treatment for all transfers of profits interest for services, including profits interests not subject to section 1061.

This posting is intended for informational purposes only, does not constitute legal advice and may not be relied upon by the reader. Any questions the reader may have on this subject should be directed to its attorney contact at Chamberlain Hrdlicka, myself or their own tax advisor.

[1] Treas. Reg. §1.721-1(b)(1). Cunningham, “Taxing Partnership Interests Received For Services,” 47 Tax L. Rev. 247 (1991); Karch, “Equity Compensation by Partnership Operating Business,” 76 Taxes 722 (1996); Banoff, “Identifying Partners' Interests in Profits and Capital: Uncertainties, Opportunities and Traps,” 85 Taxes Magazine—the 59th University of Chicago Tax Conference 197 (2007).

[2] Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5)(iii) (allows re-valuation of capital accounts upon the grant of a partnership interest in return for services. Mark IV Pictures, Inc. v. Commissioner,  TC Memo 1990-571, 60 TCM 1171, aff'd, 969 F2d 669 (8th Cir. 1992)(adjustment of distribution rights in identifying whether a capital interest has been received). Friedman, “Noncompensatory Capital Shifts: Rethinking Capital Accounts,” 107 Tax Notes 597 (2005).

[3] The lead cases in this area leading up to the Service’s issuance of Rev. Proc. 93-27 were United States v. Frazell, 335 F.2d 4487 (5th Cir. 1964); Mark IV Pictures, Inc. v. Commissioner, supra,  and Vestal v. United States, 498 F.2d 487 (8th Cir. 1974).

[4] Rev. Proc. 2001-43, supra, further announced that “[T]axpayers to which this revenue procedure applies need not file an election under §83(b).

[5] See Mandell, “The Carried Interest Controversy”, Tax Notes (10/5/2017); Abrams, “Taxation of Carried Interests: The Reform That Did Not Happen,” 40 Loy. U. Chi. L. J. 197 (2009).

[6] §1061(a)(1).

[7] The Service should make such concession in the regulations or other guidance.

[8] §751(a) treats as ordinary income the amount of money or fair market value of any property received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to unrealized receivables or inventory items. See also §1248.

[9] Treas. Regs. §§1.1223-2(a), 1223-2(b)(1).

[10] Treas. Reg. §1.1223-2(b)(2).

[11] §1061(a)(flush language).

[12] Groetzinger v. Commissioner, 480 US 23 (1987)(“to be engaged in a trade or business, the taxpayer must be involved in  the activity with continuity and regularity and… the taxpayer’s primary purpose for engaging in the activity must be for income or profit”). See also Sun Capital Partners III, LP v. New England Teamsters Trucking Indus. Pension Fund, 724 F3d 129 (1st Cir. 2013)(private equity firm were found to be “actively involved in the management and operation of companies in which they invested and therefore conduced trades or business for purposes of the Employee Retirement Income Security Act of 1974(ERISA) imposing liabilityon companies withdrawing from multiemployer pension plans. McMillan, Tax Treaty Issues in Sun Capital ‘Trade or Business’ Ruling, 140 Tax Notes 721 (Aug. 12, 2013); Rosenthal, Private Equity Is a Business: Sun Capital and Beyond, 140 Tax Notes 1459 (Sept. 23, 2013).

[13] See also Rev. Rul. 93-36, 1993-1 CB 287.

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