United States: Get Out The Backpacks: Carried Interests Must Be Carried For Longer

 On December 22, 2017, a sweeping tax reform bill (the "Tax Reform Act" or the "Act") was signed into law.1 Stroock has already released a Special Bulletin covering the implications of the Act generally.2 This Stroock Special Bulletin focuses on how the Act changes the treatment of a so-called "carried interest" and how these changes may affect the ability of a recipient of a carried interest to recognize long-term capital gain on the disposition of such interest, or a disposition of the assets held by the entity with respect to which the carried interest is issued. Carried interest programs have been the subject of media and legislative attention over the years and, despite multiple congressional efforts to eliminate the carried interest benefit, the Tax Reform Act represents the first meaningful change in the tax law applicable to such arrangements.3 As  described in further detail below, the Tax Reform Act changes are unlikely to minimize the traditional use and/or practice of many common carried interest arrangements. Nevertheless, clients and friends of the firm would be wise to consider their existing practices and forward planning carefully in light of these changes, particularly with respect to exit and disposition strategies.

Background: Carried Interest

A carried interest generally is an interest received by a general partner, sponsor, manager, employee or other service provider in the future profits of an entity treated as a partnership for U.S. federal income tax purposes. Carried interest arrangements have traditionally raised some technical issues under the Internal Revenue Code — namely whether they should be treated under the tax rules governing the transfer of property in connection with compensation, or whether they should be treated under the regime governing partnerships. While a detailed discussion of this debate is beyond the scope of this Stroock Special Bulletin, many practitioners have worked with both regimes when dealing with carried interests programs because not all arrangements necessarily "fit" within one or the other neatly or completely.

A starting point for present purposes is relief granted by the Internal Revenue Service (the "Service") addressing the grant of a bare profits interest held for at least two years. Subject to certain conditions, the Service ruled in 1993, as expanded in 2001, that the service provider may receive a profits interest without recognizing U.S. federal income tax at the time of the grant — or later vesting.4 (Many carried interests are subject to either time based or performance based vesting conditions). These Revenue Procedures have been utilized by many practitioners to structure carried interest arrangements to avoid the receipt of a compensatory profits interest resulting in U.S. federal income taxation at the time of the grant — or vesting.5 Following the guidelines outlined by these authorities, many practitioners have concluded that carried interest arrangements could be structured so that the service provider would be treated as a partner of the partnership with respect to its carried interest, as of the date of the grant thereof, and would be allocated and recognize income, gain, losses or deductions with the same character as reported by the partnership.

Of course, not all fact patterns fit squarely within this guidance, and many practitioners continued to treat the grant of such unvested awards as a possible transfer of compensatory property, as to which Section 83 of the Internal Revenue Code of 1986, as amended (the "Code") could be applicable. In such circumstances, many practitioners have advised making prophylactic Section 83(b) elections which permit a taxpayer to include the value of unvested property (in this case, arguably, the "property" being the unvested profits interest) received at the time it is granted. In this way, the recognition event for U.S. federal income tax purpose would occur at a time when the value of the "property" is less than the value over its projected lifespan.6 However, more recent proposed authority may have muddied some of the analysis.7

Carried interests structured as profits interest have often been regarded as particularly valuable where the pool of assets involved generated capital gain, rather than ordinary income. If the service provider was treated as a partner by virtue of his or her profits interest when the partnership sold a capital asset that it held for more than a year, the gain allocated to the service provider from that sale would flow through as long-term capital gain.8

Similarly, any gain from the disposition of a carried interest and attributable to capital assets owned by the partnership would be treated as long-term capital gain if the carried interest were held for more than a year. The disposition of assets or carried interests that have been held for one year or less would otherwise give rise to short-term capital gain or loss. Carried interests may often be redeemed by the issuing partnership or purchased by the other partners for cash, or sometimes be converted into straight percentage interests in the partnership going forward.

Tax Reform Act: Section 1061(a)

We expect that the Tax Reform Act modifications to carried interests will not significantly change the current practice of issuing carried interests as an alternative to making compensatory payments to service providers. Importantly, while implicitly giving a "nod" to the compensatory regime over the partnership regime, it would not appear that the Tax Reform Act impacts the U.S. federal income tax consequences associated with the non-recognition of income upon the grant of a profits interest to a service provider in exchange for services. That said, it is important to point out that to assure this treatment and the desired long-term capital gains treatment associated with the later sale or disposition of the interest, the Tax Reform Act generally now requires that the service provider hold the interest for over three years, rather than the two years called for under the existing Revenue Procedures. It also requires that assets held by the issuing partnership be retained for over three years rather than the one year under current law. Accordingly, whether the Tax Reform Act will impact particular carried interest arrangements will depend in large measure on the nature of the investments and the position or exit strategies of the issuing partnership.

Specifically, Section 13309 of the Tax Reform Act modifies the treatment of carried interests, including those granted prior to 2018, by introducing a new Code Section 1061.9 Section 1061(a) provides that gain "with respect to" (i.e., gain allocated to the holder of) an "applicable partnership interest" is treated as short-term capital gain if the gain relates to an interest or asset that has been held for three years or less (rather than the typical one-year-or-less holding period for determining whether capital gain is short-term or long-term). Accordingly, if the holder of an applicable partnership interest disposes of that interest within three years, the gain on that disposition will generally be treated as short-term capital gain.

An "applicable partnership interest" is, generally, an interest in a partnership received in connection with the performance of substantial services in an "applicable trade or business" other than certain services performed for entities other than the issuer of the interest. An "applicable trade or business" consists of a business that is regularly, continuously and substantially conducted in connection with raising or returning capital and which either invests in or develops "specified assets." "Specified assets," for this purpose, generally include stocks and securities, commodities, real estate held for rental or investment, cash or cash equivalents, and certain options, derivatives or partnership interests relating to any of the aforementioned assets. Accordingly, in light of these definitions, the new carried interest legislation is designed to apply primarily to carried interests in hedge, real estate and certain private equity funds and joint ventures. Exceptions are carved out for interests held by a corporation, and for any capital interest in a partnership where the right to share in profits is commensurate with the holder's capital contributions.

Application of Carried Interest Provisions in Section 1061(a)

As noted above, Section 1061(a) is not really a gain recognition provision, and thus, may not result in significant changes to the desired non-recognition of income by a service provider recipient of a profits interest at the time of its grant. Rather, it simply provides that if gain is recognized, it will be recharacterized as short-term capital gain if the requisite three-year holding period is not satisfied. A potential issue is how the sale of an applicable partnership interest is treated where the interest is held for more than three years but some of the assets are held for less than three years. There is a special rule dealing with transfers of carried interests to related parties that provides a look-through approach to treat any gain recognized with respect to assets of the partnership not meeting the three-year requirement as short-term capital gain. However, absent any language in the statute to the contrary, we believe that there is no look-through concept in the case of a disposition to an unrelated party.

There are a number of questions prompted by these new provisions. One question is how Section 1061(a) is meant to apply to carried interests with contingent profit-sharing ratios that are subsequently converted into fixed-percentage interests in a partnership. Consider, for example, a carried interest award granted as a profits interest that, as time passes, is later converted into a straight partnership interest. Does the conversion itself potentially taint the later disposition of the interest by restarting the three-year holding period as of the date of conversion?

In addition, it is uncertain whether carried interest arrangements with portfolios of assets of real property are exempt from recharacterization under Section 1061(a). Section 1061(a) serves to convert what otherwise would be "long term capital gain" as defined in Section 1222, into short-term capital gain. However, under Section 1231, gain from certain real estate and other property used in a trade or business is treated as long-term capital gain without regard to Section 1221. Since real estate is expressly included in the definition of "specified assets", it would be expected that the sale of real estate held under a carried interest arrangement would be covered by the rules of Section 1061(a). However, the ambiguity created by the dichotomy in defining long-term capital gain will have to be resolved through future guidance from the Service.

Examples of Application of Section 1061(a)

The following scenarios illustrate the mechanics of how, subject to confirmation through clarifying guidance, practitioners generally understand Section 1061(a) to operate.

(A) A partner ("P") holds an applicable partnership interest for two years, then sells the partnership interest. Previously, P would have recognized long-term capital gain, but under Section 1061(a), this gain is recharacterized as short-term capital gain.

(B) P has held an applicable partnership interest for four years, but the partnership has only held Asset X for two years and the partnership now sells Asset X. As partnerships are pass-through entities, P would recognize capital gain in the amount of its proportionate share of the partnership gain. Section 1061(a) would apply to P's gain with respect to its partnership interest, and accordingly recharacterize P's share of the partnership's gain as short-term capital gain.

(C) As in (A), P has held an applicable partnership interest for two years and the partnership has held Asset X for four years. The partnership now sells Asset X and recognizes gain. P's share of such gain would presumably not be recharacterized, and would be treated as long-term capital gain.

(D) As in (B), P has held an applicable partnership interest for four years, but the partnership has only held Asset X for two years. P now sells its partnership interest to an unrelated party (but the partnership continues to own Asset X). Section 1061(a) does not seem to apply to this transaction, as the gain recognized by P with respect to the partnership interest is the gain on the sale of such interest and the asset being sold is the partnership interest itself, which has been held for more than 3 years. Thus it is expected that P would recognize long-term capital gain.

(E) As in (D), P has held an applicable partnership interest for four years, but the partnership has only held Asset X for two years. P sells its partnership interest to T, who is related to P and was not previously a partner in the partnership. Assume that P recognizes long-term capital gain on the sale and that the partnership has a Section 754 election in place.10 Accordingly, T may be entitled to a "step-up" in the tax basis of Asset X such that a subsequent sale by the partnership of Asset X within that year would not result in any taxable gain for T. Thus, in the absence of Section 1061(d), P would recognize only long-term capital gain on P's sale of the partnership interest to T, whereas P would have had to recognize short-term capital gain had Asset X been sold while P was still a partner in the partnership. In this situation, it appears that Section 1061(d) would recharacterize a portion (attributable to Asset X) of P's gain on the sale of its partnership interest to T as short-term capital gain.

Take-Away

The Tax Reform Act will likely not have a significant impact on the continued proliferation of carried interest arrangements. However, although the benefits have not been eliminated entirely (as many times threatened in Congress), recipients of carried interests will have to be more cognizant of the holding periods for their interests and for the timing of disposition of partnership assets. To the extent that three years is viewed as too long a period to hold, or bear economic risk with respect to, assets or investments, it is expected that novel and sophisticated strategies will develop to permit sponsors and service providers the ability to lock in their profits. The reach of the new legislation is broad, affecting all kinds of funds and joint ventures.

Stroock's tax team is dedicated to staying ahead of the game on all strategies and developments in this area, and is available for further consultation on these matters.

Please note that the above is not intended to be tax advice and that no attorney-client relationship is created between Stroock and any reader. However, the Stroock tax team's contact information can be found below if you have further questions about the above changes, how they will affect real estate transactions going forward, and how they may affect you or your business.

Footnotes

 1 P.L. 115-97.

2 "The Largest Tax Reform in 30 Years," Stroock Special Bulletin, available at https://www.stroock.com/siteFiles/Publications/TheLargestTaxReformIn30Years2017.pdf

3 Most notably by Congressman Levin (D-Michigan), through the Extenders Act of 2010, but also others in the past have proposed changes to the U.S. Federal income tax considerations associated with carried interests. See also the American Jobs and Closing Loopholes Act of 2010 (H.R. 4213), which would have been effective in 2011 had it been enacted.

 The Senate passed a similar bill in 2010, the American Jobs and Tax Cuts Act of 2010 (S. 3793). Before 2010, the House passed several bills that would have enacted a new Section 710 to the Code that would have treated as ordinary income amounts attributable to a service partner's carried interest.

4 Rev. Proc. 93-27, 1993-27 C.B. 343. Rev. Proc.

2001-43, 2001-34 I.R.B. 191. A profits interest confers the right to share in the enterprise's future profits. By contrast, a capital interest provides the holder with the right to receive a share of the proceeds of the partnership after giving effect to a liquidation. See also Diamond

v. Commissioner [Dec. 30,838], 56 T.C. 530 (1971), affd. [74-1 USTC ¶ 9306]492 F.2d 286 (7th Cir. 1974); Campbell v. Commissioner, 59

T.C.M. (CCH) 236 (1990), rev'd, 943 F.2d 815(8th Cir. 1991); Diamond v. Commissioner [Dec. 30,838], 56 T.C. 530 (1971), affd. [74-1 USTC ¶ 9306] 492 F.2d 286 (7th Cir. 1974). Seealso Treasury regulation section 1.83(a).

5 Rev. Proc. 2001-45 2001-2 C.B. 191.

6 For example, the Revenue Procedures do not apply to interests that are anything but a profits interest, do not apply to interests in partnerships that have assets with predictable streams of income (i.e., a portfolio of tax exempt bonds), or interests which are transferred within two years of the grant. Many practitioners have debated whether a profits interest is or is not "property" for purposes of Section 83 or otherwise. Treasury regulation section 1.83(a) "(the term property includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future)" [Emphasis supplied].

There are other technical issues associated with the tension between the Code's partnership and compensation for property rules. The regulations generally require partnerships to maintain a Section 704(b) book value capital account for each partner to reflect the partner's economic interest in the partnership. By contrast, Section 83 uses a discounted fair market value methodology. For purposes of a prophylactic Section 83(b) election, should the employee report as income the Section 83(b) value or the Section 704 value of the interest? We believe the latter would be more consistent with the general view of the IRS on carried interests.

7 See, Notice 2005-43, 2005-1 C.B. 1221 (May 24, 2005).

8 Of course, as a commercial matter, they have also been regarded as arrangements designed to align investor and service provider interests.

9 Unless otherwise stated, "Sections" herein refer to the Internal Revenue Code of 1986, as amended.

10 Section 754 permits, among other things, the purchaser of an interest in a partnership generally to step-up the tax basis of the underlying assets of the partnership.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions