Not Getting Carried Away by New Carried Interest Proposed Regulations

This past Friday, the IRS and the Treasury Department released the proposed carried interest regulations. The carried interest provision, which was added to the Code by TCJA, recharacterizes certain net long-term capital gains of a partner that holds one or more applicable partnership interests as short-term capital gains. The following is a high-level summary of the key points of the proposed regulations.

Background

In general, gain from the sale or exchange of a capital asset held for more than one year is treated as long-term capital gain.  Individual taxpayers get a favorable tax rate on long-term capital gains, a 20 percent rate on capital gain as compared to a top marginal tax rate of 37 percent on ordinary income.  The TCJA enacted Section 1061 which imposes a three-year holding period (not the generally applicable one-year holding period) in the case of long-term capital gain attributable to applicable partnership interests (“APIs”). Gain attributable to an API can include a distributive share of gain or loss from the sale of underlying assets held by the partnership or gain or loss from the sale of the API itself (“API Gains and Losses”).  If the holder of an API recognizes a difference between API Gains or Losses attributable to assets that satisfy the three-year holding period and those that do not, such difference is treated as short-term capital gain or loss and is subject to tax at the rates applicable to ordinary income (the “Recharacterization Amount”).

APIs

In general, an API is a partnership interest held by or transferred to, a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or by any other related person, in any applicable trade or business (“ATB”). However, an API does not include:

• An interest held by a person who is employed by another entity that is not conducting an ATB and provides services only to such other entity.
• Any partnership interest that is held directly or indirectly by a C corporation (excluding a PFIC with respect to which a shareholder has a QEF election in effect).
• Certain capital interests in the partnership (“Capital Interest Gains and Losses”)
• Certain partnership interests that would be treated as an API but are bought by unrelated purchasers that are not service providers to the ATB.

ATB

For this purpose, an ATB includes any activity conducted on a regular, continuous, and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of:

• Raising or returning capital (“Raising or Returning Capital Actions”), and
• Either (A) investing in (or disposing of) certain assets (the “Specified Assets”) or identifying Specified Assets for such investing or disposition (“Investing Actions”), or (ii) developing Specified Assets (the “Developing Actions”).

Unfortunately, the determination of whether the performance of services was in an ATB is not necessarily straightforward:

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