Open questions on the impact of the new law to hedge funds, private equity funds and real estate funds
The Tax Cuts and Jobs Act of 2017, P.L. 115-97 (the Act), enacted new Code section 1061. The Act was signed into law on Dec. 22, 2017. New Code section 1061 is effective for taxable years beginning after 2017 and has changed the holding period for capital gains realized by a taxpayer who holds an applicable partnership interest (as defined below). Under the new law, a taxpayer who holds an applicable partnership interest will recognize net long-term capital gain with respect to such interest only if the taxpayer has held the interest for at least three years. If the three-year holding period requirement is not met, the taxpayer’s net long-term capital gain will be treated as a short-term capital gain, notwithstanding Code section 83 or any election made under Code section 83(b).
It should be noted that short-term capital gains are potentially subject to tax at federal ordinary income rates of 37 percent, plus the 3.8 percent Medicare tax on unearned income, if applicable. In addition, the three-year holding period rule applies to capital gains recognized after 2017, regardless of when the taxpayer acquired the applicable partnership interest.
New Code section 1061 will affect many hedge funds, private equity funds and real estate funds.
Code section 1061(c)(1) defines an applicable partnership interest to mean any interest in a partnership which, directly or indirectly, is transferred to, or is held by, the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. The statute excludes any interest held by a person who is employed by another entity that conducts a trade or business (other than an applicable trade or business (as defined below)) and only provides services to such other entity. Code section 1061(c)(1) (last sentence).
Code section 1061(c)(2) defines the term applicable trade or business to mean any activity that is conducted on a regular, continuous and substantial basis, regardless if such activity is conducted in one or more entities, and consists, in whole or in part, of:
Under Code section 1061(c)(3), the term specified assets means:
The House Ways and Means Report (the House Report) explains that a security means any
The House Report states that a commodity means any
Closely-held partnership interest
As noted above, the statute does not list a non-publicly traded, closely held partnership interest as a specified asset. However, the House Report explains that a partnership interest, for purposes of determining the proportionate interest of a partnership in any specified asset, includes any partnership interest that is not otherwise treated as a security, for example, a partnership interest that is not widely held or publicly traded. The House Report illustrates the case where a hedge fund acquires an interest in an operating business that is operated in a non-publicly traded, closely held partnership and concluded that the partnership interest is a specified asset for purposes of Code section 1061. Several commentators speculate that the failure to mention closely held partnerships in the statute may be a drafting error. See Elizabeth L. McGinley and Steven J. Lorch, The New Three-Year Holding Period for Carried Interests, Bloomberg BNA Daily Tax Report (February 26, 2018).
Exclusion of corporations, including S corps
The carried interest rules exclude certain partnerships from the definition of an applicable partnership interest. Specifically, an applicable partnership interest does not include any partnership interest that is held by a corporation. Code section 1061(c)(4)(A). Neither the statute nor the legislative history elaborates on what is meant by a corporation. However, on March, 2018, the IRS issued Notice 2018-18 which announced that future regulations will clarify that the term corporation does not include an S corporation.
Capital interest in a partnership
Another carve out from the definition of applicable partnership interest is the case where a taxpayer owns a capital interest in the partnership which permits the taxpayer to share in partnership capital commensurate with (a) the amount of capital contributed, or (b) the value of such interest that was subject to tax under Code section 83 upon issuance or vesting. Code Section 1061(c)(4)(B). Notwithstanding the foregoing, the House Report explains that a partnership interest will not fail to be treated as transferred or held in connection with the performance of services merely because the taxpayer made contributions to the partnership.
Sale to a related party
Finally, Code section 1061(d) provides a look-thru/aggregate approach in the case of the sale of an applicable partnership interest to a related person. Under Code section 1061(d), if a taxpayer transfers an applicable partnership interest to a related person (as defined below) the taxpayer is required to include in gross income as short-term capital gain the excess (if any) of: (a) the taxpayer’s net long-term capital gain attributable to the sale of an asset held not more than three years as is allocable to the interest; over (b) any amount treated as a short- term capital gain under the general rule with respect to the transfer of the interest. The House Report explains that the related party sale rule should not result in double counting short-term capital gain. The term related party means a person related to the taxpayer if: (a) such person is a member of the taxpayer’s family within the meaning of Code section 318(a)(1); or (b) such person performed a service within the current calendar year or the preceding three calendar years in any applicable trade or business in which or for which the taxpayer performed a service.
Obviously, there are many questions that need to be addressed in the coming months as the industry and its practitioners come to terms with all the nuances and questions raised by newly enacted Code section 1061. Hopefully, the U.S. Treasury Department and IRS will issue new regulations answering some of these questions. Indeed, many of the references to the legislative history mentioned above may require regulations or other guidance to become fully implemented. We recommend speaking with your Baker Tilly tax advisor to understand how Code section 1061 and future guidance may affect your organization. Our team will continue to follow developments and keep our clients updated.
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