Working on a financial graph at the table

Authored by Joseph Schlueter

The Tax Cuts and Jobs Act of 2017 (TCJA) enacted legislation to address partnership carried interests. On July 31, 2020, the Treasury Department finally published long-awaited proposed regulations. This article will address some of the primary considerations for impacted partnerships and taxpayers as the end of the year approaches.


Following almost a decade of being tossed around like a political football, the partnership “carried interest” finally became the subject of direct legislation in 2017. Historically, a carried interest represented a special allocation of profit to the managers of a fund that achieved not only a specified base return for its capital investors, but also significant additional profit above that threshold. The standard split on the excess profit above the targeted return has been 20% for the manager and 80% for the investors. In the arena of investment partnerships and funds, this additional profit would typically be in the form of capital gains recognized on the underlying investments or in the sale of the partnership interest received, thus providing the holder of the carried interest with income taxed at favorable rates in exchange for the management and investment service provided. The rules outlined in section 1061, as enacted in the TCJA, seek to minimize the potential favorable rates for carried interests by requiring a holding period of three years for long-term capital gain treatment instead of the typical one-year holding period.

Although the carried interest structure originated and grew primarily in the financial services industry, the carried interest as well as the related issuance of a profit interest to employees has gained widespread usage through a variety of industries. In turn, this made it difficult to craft legislation to specifically target Wall Street — the primary political target of the legislation. As with any targeted piece of tax legislation, regulations become an important part of defining the boundaries of the rules. With the issuance of proposed regulations in 2020, application of the law gains greater clarity.

The general carried interest rules

The carried interest rules revolve around a few key concepts, most notably applicable partnership interests (APIs) that are issued to a taxpayer in connection with the performance of substantial services in an “applicable trade or business.” The term applicable trade or business is defined in the Internal Revenue Code to mean any regular and continuously conducted activity that consists in whole or in part of raising or returning capital, and either invests in or develops “specified assets.” Specified assets are, in turn, defined in general as securities, commodities, real estate held for rental or investment, cash or cash equivalents, or options or derivative contracts with respect to any such assets. These definitions, as contained within the IRC, were intended to carefully target the three-year holding period rule of section 1061 to specific taxpayers.

The 2017 legislation included broad authority for the Treasury Department to issue regulations or similar guidance to carry out the purposes of the carried interest law. The tax law as written in the IRC left several important questions unanswered, primarily around the determination of holding periods in both partnership assets as well as partnership interests.

Overview of the regulations

The proposed regulations define key terms, clarify issues related to holding periods, describe in greater detail calculation of the amounts subject to section 1061 treatment, provide rules applicable to tiered partnership structures and outline various exceptions, reporting rules and transfers of partnership interests to related parties. For the purpose of year-end tax planning, this article will focus on the holding period issues.

Primary year-end considerations

For a partnership and its partners subject to the rules under section 1061, as noted above, the rule will recharacterize certain net long-term capital gain with respect to an API. Capital gains that do not meet a three-year holding period are treated as short-term capital gains and, therefore, taxed at ordinary rates. Two potential exit transactions can occur with respect to an API: a sale of the partnership interest or a sale by the partnership of underlying investment assets.

Sale of assets

If a partnership sells assets, the proposed regulations properly clarify that the partnership’s holding period in the assets sold will control the treatment of the sale, irrespective of the length of time partners have held their interest in the partnership. For example, if Able has held her partnership interest for two years and API partnership sells an investment asset that it held for four years, the four-year holding period will control the ultimate treatment of any gain on sale. This is consistent with long-established partnership rules and is certainly a taxpayer-favorable aspect of the proposed regulations. If an API is considering the sale of assets held for more than three years, but is concerned about the tax treatment for individuals holding interest in the API for less than three years, the proposed regulations clarify that long-term treatment will be retained for the resulting gain.

Sale of partnership interests

In the sale of a partnership interest, the proposed regulations provide for a look-through to the underlying assets held by the partnership to impact the final determination of the holding period to be applied to any gain on the sale of the partnership interest. Upon the sale of an interest in an API, the first determination will be with respect to the period of time such interest was held by the partner. For example, if Able held her interest in API partnership for four years at the time of sale to an unrelated third party, the proposed regulations apply Able’s holding period to the section 1061 determination, subject to the look-through. The general look-through rule will apply if “substantially all” of the assets of the partnership are “specified assets” that have been held for three years or less. “Substantially all” for this purpose is defined as 80% or more of the fair market value of the assets. For a fund that might typically turn its portfolio investments in less than three years, this look-through rule will be extremely difficult to maneuver around, even when an individual’s ownership of an API exceeds three years.

Add-on investments to portfolio companies

An area that was not specifically addressed in the proposed regulations but that may be a consideration in 2020 involves the treatment of the holding period of an investment in a portfolio company if the API makes an additional investment in the portfolio company but does not take back additional shares of stock, for example. The questions presented in this type of situation are whether a new holding period will be created or will the existing holding period be tacked on to the new investment. With the lack of direct guidance on this point, affected partnerships might consider making such investments through loans rather than equity or, if debt needs to be avoided, consider a special class of preferred equity to limit potential future appreciation to the newly issued class of stock, thus limiting the potential exposure to section 1061 treatment.


The carried interest rules enacted in 2017 are narrowly targeted to specific taxpayer situations. The proposed regulations issued in 2020 did not increase the overall scope of section 1061’s reach and are generally favorable for taxpayers, all things considered. For partnerships that fall within the reach of section 1061, the proposed regulations provide some much-needed guidance and clarity on issues related to the holding period and should assist with understanding the overall impact on affected partners as it relates to the sale of underlying partnership assets as well as the rules that will be applied to sales of the partnership interests.

For more information on this topic, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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