Many of the provisions in the TCJA will have a significant impact on individual taxpayers as well as all types of business entities, including partnerships and limited liability companies (LLC) that are taxed as partnerships. However, there are some specific provisions of the TCJA that will impact only partnerships and LLCs. This Update is the first of two that will address those specific provisions in greater detail.
The TCJA leaves relatively untouched the favorable tax treatment provided for carried interests (sometimes also referred to as “sweat equity” interests or profits interests) in entities that are taxed as partnerships. Carried interests provide the holder with a share of the partnership’s profits that is larger than the holder’s percentage interest in the capital invested in the partnership. The tax law has generally allowed the sponsor, general partner, developer, managing member, or employee of a partnership, LLC, REIT, private investment fund, or real estate joint venture to (a) avoid taxation on the receipt of such an interest and (b) obtain favorable long-term capital gain treatment, rather than ordinary income treatment, on the sale of such an interest if certain requirements are satisfied.
One such requirement was that the partner hold their carried interest for longer than a year. However, under the TCJA, to qualify for long-term capital gain with respect to an applicable partnership interest, such gain must now be attributable to assets held by the partnership for more than three years, or if the carried interest itself is sold or transferred, the interest must have been held for more than three years.
To the extent that the assets or the carried interest was not held for the necessary three-year period prior to either its sale or its transfer to a related party, the resulting gain will be treated as a short-term capital gain and therefore taxed to the partner at ordinary income tax rates, not long-term capital gain rates. Although the gain will be taxed at ordinary income tax rates, it should not be subject to self- employment tax, which earlier proposals had initially suggested.
An applicable partnership interest is any interest in a partnership that, directly or indirectly, is transferred to or held by the taxpayer in connection with the performance of substantial services by the taxpayer (or a related person) in any applicable trade or business. A definition of substantial services has not yet been provided. An applicable trade or business is defined as any activity:
- Conducted on a regular, continuous, and substantial basis
- That consists in whole or in part of raising or returning capital and either
- Investing in or disposing of specified assets or identifying specified assets for investment or disposition or
- Developing specified assets
Specified assets are defined to include securities, commodities, real estate assets, cash, and derivatives. This definition of specified assets from the statute does not include an interest in a closely held partnership operating a trade or business, but the Conference Report does include such a partnership interest in its discussion of specified assets.
Note that this change in the holding period is effective for capital gains the taxpayer recognizes on or after January 1, 2018. The TCJA does not include a grandfather provision for carried interests granted prior to the effective date of the TCJA; those previously issued interests are also subject to the new three-year holding period.
The new provision contains an exception for carried interests held by a corporation (directly or indirectly). The statute does not specifically state that to qualify for the exception the corporation must be a “C corporation.” However, subsequently issued guidance has indicated the Treasury’s intent that the corporation must in fact be a C corporation, eliminating the tax strategy of holding the carried interest in an S corporation to avoid this new three-year holding period.
The new provision does not apply only to sales; it also provides that upon transfer of an applicable partnership interest to a related person, the transferor may have to recognize a short-term capital gain, even in a nonrecognition transaction (such as a gift). However, the practical application of this rule is not clear based on the statute and Conference Report. It appears that such a transfer would trigger recognition of a gain with respect to capital assets held for more than one year but not more than three years, even if the partnership interest itself had been held for more than three years. Hopefully, further guidance will be forthcoming.
For taxpayers in private equity funds, who generally hold their carried interest or the partnership’s underlying assets for at least three years, this holding period will not be an issue. However, many real estate developers will build and sell after a year or two once the property has been stabilized and may therefore need to take this new holding period into consideration when calculating the after-tax economics of a sale of the property or their carried interest.
However, for carried interests that are related to a real estate rental entity, there may still be a way to avoid the three-year holding requirement. The new provision references paragraphs (3) and (4) of preexisting Sec. 1222 and substitutes three years for one year in those provisions. Sec. 1222 deals with capital gain income, not Sec. 1231 gain. Sec. 1231 gain is gain from the sale of depreciable property used in a trade or business, such as rental property. Gain from the sale of Sec. 1231 property is taxed as a capital gain, but it is not technically a capital gain. It is not clear whether Congress intentionally or unintentionally failed to include Sec. 1231 property within the scope of this new three-year holding requirement. However, lacking a correction, it appears there may be a position for a partner who is allocated Sec. 1231 gain from the partnership with respect to their carried interest to report such income as a long-term capital gain, even if they have held their carried interest for less than three years. This position would likely work only with respect to the sale of the partnership’s Sec. 1231 assets, not the partner’s sale of their carried interest.
Unfortunately, guidance on this new carried interest holding period is unlikely to be issued this year. It is not included in the IRS’s current Priority Guidance Plan. Instead, the IRS will be focusing first on issuing guidance on those provisions of the TCJA which will impact a far greater number of taxpayers — such as the 20% flow-through deduction, the 30% limitation on business interest expense, and 100% bonus depreciation.