The IRS issued proposed regulations (REG-107213-18) on the tax treatment of carried interests. Carried interests are ownership interests in a partnership that share in the partnership's net profits. They are often transferred in connection with the performance of substantial services by an individual. Proceeds from that individual's partnership interest are often taxed as capital gain rather than ordinary income. The law known as the Tax Cuts and Jobs Act, P.L. 115-97, extended the holding period for certain carried interests, applicable partnership interests (APIs), to three years to be eligible for capital gain treatment.
The proposed regulations include:
- Prop. Regs. Sec. 1.1061-1, which provides definitions of the terms used in the proposed regulations.
- Prop. Regs. Sec. 1.1061-2, which provides rules and examples regarding APIs and applicable trades or businesses (ATBs).
- Prop. Regs. Sec. 1.1061-3, which provides guidance on the exceptions to the definition of an API, including the capital interest exception.
- Prop. Regs. Sec. 1.1061-4, which explains how to compute the recharacterization amount and contains examples on how to compute it.
- Prop. Regs. Sec. 1.1061-5, which explains the related-party rules and how they apply to Sec. 1061(d).
- Prop. Regs. Sec. 1.1061-6, which provides reporting rules.
- Prop. Regs. Sec. 1.1223-3, which contains rules for determining a divided holding period when a partnership interest includes an API and/or a profits interest. These clarifying amendments are provided because Sec. 1061 requires a clear determination of the holding period of a partnership interest that is, in whole or in part, an API.
The proposed regulations also include related clarifying amendments to Regs. Sec. 1.702-1(a)(2) and Regs. Sec. 1.704-3(e).
In Notice 2018-18, the IRS had stopped taxpayers from using an S corporation to avoid the carried interest rules by saying that, for purposes of the carried interest rules, a "corporation" for purposes of Sec. 1061(c)(4)(A) does not include an S corporation. Under Sec. 1061(c)(4)(A), an API does not include any interest in a partnership that is directly or indirectly held by a corporation. The proposed regulations reiterate this provision, meaning that partnership interests held by S corporations are treated as APIs if the interest otherwise meets the API definition.
The proposed regulations also extend this treatment to encompass certain partnership interests held by a passive foreign investment company (PFIC) for which a taxpayer has a qualifying electing fund (QEF) election in effect, treating that interest as an API if the interest meets the API definition.
The proposed regulations contain a transition rule for partnership property that was held by the partnership for more than three years on Sec. 1061's effective date. A partnership that was in existence as of Jan. 1, 2018, may irrevocably elect to treat all long-term capital gains and losses from the disposition of all assets, regardless of whether they would be API gains or losses in prior periods, that were held by the partnership for more than three years as of Jan. 1, 2018, as partnership transition amounts. Partnership transition amounts that are allocated to the API holder are not taken into account for purposes of determining the recharacterization amount. Rather, they are treated as long-term capital gains and losses and are not subject to recharacterization.