Carried Interest arrangements, which are mainly used in partnership and LLC settings for private equity and alternative asset funds (to wit; hedge, real estate, energy, infrastructure, and fund of funds), have historically provided, to a management/marketing person, the ability to share in the net revenues as a partner, or member of a limited liability company (a “Carried Interest” held by a “Carried Partner”), without the Carried Partner actually contributing capital or property to the partnership, as a normal partner would.
The word “partner” will be used in this discussion to include a member of a limited liability company and a partner in a partnership.
Carried Partners and their tax advisors have often taken the position that the sale of a Carried Interest, if held for a long-term capital gain holding period of one year or more, will generate capital gain income – rather than ordinary income. The “Regulations”, described below, provide a requirement that the holding period for a Carried Interest is three years in order for the sale of the same to generate capital gain.
This result is claimed, despite the fact the Carried Partner was never an actual contributor of capital to the partnership, or an owner of actual capital in the partnership. (To wit.; no capital asset existed which was capable of being sold in a capital gain transaction.)
Various attempts have been made by Congressmen and Senators over the years to control this area, since the Carried Partner claim of capital gain treatment, upon sale, has been criticized as tax abuse.
On July 31, 2020, the Internal Revenue Service issued carried interest proposed regulations (the “Regulations”), which are based on a section of the Internal Revenue Code (“Code”) added to the Code in 2017. This being Section 1061, which generally imposes a three-year holding period requirement for Carried Interest arrangements.
Where it applies, IRC Section 1061 recharacterizes gains arising from the sale of capital assets, held for only one to three years, otherwise claimed to generate long-term capital gain, as short-term capital gains, typically taxed at the rates applicable to ordinary income.
Code Section 1061(a) applies to taxpayers that hold “applicable partnership interests" (“APIs”). An API is defined as a partnership interest that is transferred to, or held by, a taxpayer in connection with the performance of substantial services by the taxpayer or any related person in an “applicable trade or business” (“ATB”).
ATB defined: An ATB is defined by the statute as any activity conducted on a regular, continuous, and substantial basis, which, regardless of whether the activity is conducted by one or more entities, consists, in whole or in part, to include:
(A) raising or returning capital (“Raising or Returning Capital Actions”); and
(B) either (i) investing in (or disposing of) specified assets, or (ii) developing specified assets (to wit, “Investing or Developing Actions”).
Genuine capital interests are excluded from treatment as APIs, such as any capital interests in the partnership which provide the taxpayer with a right to share in partnership capital commensurate with (i) the amount of capital contributed or (ii) the value of such interest subject to tax under Section 83 of the Code (property given to a service provider) upon the receipt or vesting of such interest.
The Regulations contain a “Look Through Rule”, which determines whether a three-year holding period will be respected, or whether it will be recharacterized as a one to three-year holding period. A three-year holding period will be respected where a “Substantially All” test is met. Generally, the “Substantially All” test is met if 80% or more of the partnership’s assets (i) are assets that would produce capital gain or loss if disposed of by the partnership and (ii) have a holding period of three years of less.
There are, of course, limiting exceptions to transactions between related taxpayers, which would negate capital gain treatment.
Passthrough entities, whether partnerships or LLCs, must report Code Section 1061 Information to Owner Taxpayers on an attachment to the Schedule K-1, including:
(i) Reporting each partner’s share of (a) long-term capital gains and long-term capital losses from assets held more than one year and (b) such gains and losses from assets held for more than three years.
(ii) Long-term capital gains and long-term capital losses allocated to the API holder that are excluded from the limited capital gain or loss limitation.
(iii) Gains or losses allocated to the API holder qualifying for the capital interest exception (to wit; actual capital contributed to the activity by a partner).
Not doing so can result in normal federal tax penalties, such as those under Code section 6698, Failure to File Partnership Returns, and Code section 6722, Failure to Furnish Correct Payee Statements.
Example of a Carried Interest:
Fund manager P holds a profits interest in a partnership that he received in connection with the performance of services. P’s separately stated net long-term capital gain in connection with the interest is $200 million. However, only $150 million of that amount is attributable to underlying investments that have been held for more than three years. P will be treated as having $150 million of long-term capital gain, which will be taxed at capital gains rates, and $50 million of short-term capital gain which will be taxed at ordinary income tax rates.
The holding period change from more than one to more than three years is imposed on individual profits partners in partnership whose business is raising or returning capital, or investing in specified assets, including securities, commodities, cash or cash equivalents, and real estate investments. Although the longer holding period seeks to reduce the amount of investment eligible for lower long-term capital gain rates, its impact may in fact be limited, since the average holding period for private equity fund managers is greater than three years. Most private equity managers who buy companies, restructure and refinance them, and then sell them, and most real estate partnerships, already hold their underlying assets for six or more years. Thus, the longer holding period required for long term capital gain treatment could affect shorter duration investment assets, such as those of hedge fund managers, who invest for shorter periods just by nature of the underlying assets of the partnerships.