Tax Reform Series #7: Carried Interest Extended to 3-Year Holding Period

The Tax Cuts and Jobs Act of 2017 (“TCJA”) adoption of Internal Revenue Code (“Code”) Section 1061 is targeted at hedge and private equity funds.

The TCJA extends the holding period for favorable long-term capital gain treatment related to “applicable partnership interests,” which are often referred to as carried interests or profit interests. Code Section 1061 defines an applicable partnership interest as an interest in a partnership that is transferred to a taxpayer in connection with the performance of substantial services by the taxpayer in an “applicable trade or business.”

Code Section 1061 defines an applicable trade or business as any activities conducted on a continuous basis that involves raising or returning capital and investing or developing “specified assets.” Specified assets are defined as securities, commodities, real estate held for rental or investment, cash or cash equivalents, and options or derivative contracts. Therefore, the three-year holding period only applies to those assets that are held for portfolio investment on behalf of third-party investors.

The TCJA included specific examples that would not be subject to the extended holding period. Taxpayers that made a proper Code Section 83(b) election would not be subject to the extended holding period. Additionally, taxpayers that have the right to share in the partnership capital in proportion to his or her capital contributed.

Furthermore, the Code Section 1061 provides that applicable partnership interests held by corporations are not subject to the extended holding period. Where do S Corporations stand when awarded carried interests? The Internal Revenue Service (“IRS”) quickly issued Notice 2018-18 that explicitly stated S Corporations are subject to the extended holding period; only C Corporations are excluded. It should be noted that there is some question as to the IRS’ authority to issue the Notice.

The TCJA’s change to the holding period requires more strategic planning when analyzing carried interests; for example, any closely-held partnership that has a waterfall payment schedule should be analyzed to determine the impact of this change, if any.

To discuss various strategies or analyses, please contact us.