Planning Ideas for Avoiding IRC § 1061's Three-Year Holding Period Requirement
Investment fund managers value compensation in the form of carried interests, which allows them to be compensated for services with income that qualifies for long-term capital gains tax treatment. Numerous efforts have been made during the past decade to cut back or eliminate the favorable tax treatment of carried interests.
Reports indicate that during the negotiations of the 2017 Tax Cuts and Jobs Act, White House economic advisor Gary Cohn campaigned to end the benefit of carried interest by taxing all income from carried interests as ordinary income, while Treasury Secretary Steven Mnuchin urged keeping the prior tax treatment with new limits.1 Mnuchin prevailed with the enactment of IRC § 1061, despite President Trump’s campaign promise to end the so called “carried interest loophole.”
IRC § 1061 increases the holding period required for long-term capital gains treatment from more than one year to more than three years for an "applicable partnership interest." Prior to the enactment of IRC § 1061, a carried interest might be issued on Tuesday, and if the partnership sold a capital asset with a long-term holding period on Wednesday, the holder could share in the pass-through of long-term capital gains on the sale. The same hedge fund professional could sell his interest after a year and claim long-term capital gains treatment. Today, this same hedge fund professional would have short-term capital gains in both scenarios.
While IRC § 1061 doesn't change the basic favorable treatment of carried interests (which are typically nontaxable at the time of issuance, can participate in the pass-through of long-term capital gains and be sold as a capital asset, in each case avoiding employment taxes), fund professionals will need to keep IRC § 1061 in mind when structuring compensation arrangements.
In a recent article, we discussed the impact of the new IRC § 1061 and provided a summary of its rules. This article discusses several potential planning opportunities regarding the new three-year holding period requirement.
While future corrective legislation and agency and legal interpretations may target IRC § 1061 planning, the statute in its current form provides opportunities for taxpayers work around the negative consequences of the three-year holding period. The planning opportunities discussed below may be available to taxpayers given the right facts and circumstances.
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Attorneys at Frost Brown Todd have developed substantial experience assisting business clients in structuring their incentive compensation arrangements. If you need assistance or would like additional information, contact Scott Dolson, Ben Hager, Nelson Rodes or any other member of the Tax Law Practice Group for Tax Law Defined™.
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Daniel G. Mudd is a member of FBT, handling federal, state and local tax matters, including sales and use, excise (e.g., alcohol and tobacco), income, local occupational license and business taxes.