Article prepared by FGMK Tax Partner, Perry Weinstein and Tax Senior Associate, Jeffrey Golds
Pursuant the Tax Cuts and Jobs Act of 2017, Section 1061 of the Internal Revenue Code (the “Code”) requires that income related to certain partnership interests is taxed as short-term capital gains (likely taxable at ordinary income tax rates unless offset by capital losses) unless and until such partnership interest was held for three or more years. The rule applies to income from an “applicable interest” in a partnership, which is one which is received in connection with the performance of services related to an “applicable trade or business”. An applicable trade or business is one which consists, in whole or in part, of raising or returning capital, and either investing in or disposing of specified assets or developing specified assets. Specified assets include commodities, real estate held for rental or investment, cash or cash equivalents, options, derivatives, or interests in partnerships investing in any such assets. Under Section 1061(b), gain or loss from an asset which is not held for portfolio investment on behalf of third party investors will not be subject to the three year holding period. Therefore, any partnership in which all partners share responsibility in managing the assets will be excluded from Section 1061, even if one or more of the partners received interests in exchange for services. Additionally, in partnerships where all members contribute capital but some receive a greater interest in exchange for management services should be exempt under Section 1061(b). In general, any closely held LLCs which have a waterfall payment schedule in the partnership agreement should be closely examined to determine whether the exemption under Section 1061(b) applies.
Section 1061 excludes certain interests from qualifying as “applicable partnership interests”, including any interest in a partnership directly or indirectly held by a corporation. As the Code only specifies that a partnership interest held by “a corporation” is excluded, there was uncertainty as to whether a partnership interest held by an S-corporation would be excluded from the application of Section 1061. However, under Notice 2018-18, the IRS has clarified that, under Section 1061, “a corporation” only includes a C-corporation, and that a partnership interest held by an S-Corporation will not be excluded from the application of section 1061. This change is effective for tax years beginning after December 31, 2017, so there is no opportunity to grandfather in any partnership interests which were held by S-corporations prior to the IRS notice. However, it is worth noting that several lawsuits have been filed challenging the IRS’s authority to issue such notice, so it is possible that limiting the exception to C-Corporations will require a legislative fix.
Additionally, an applicable interest does not include one the value of which is commensurate with the amount of capital contributed at the time of receipt of such interest, or where the value of the interest was taxed under Code Section 83 at the time of vesting of such interest. These exceptions remove the majority of most joint ventures from the scope of the provision. To the extent that each partner contributes capital at the formation of a partnership, Section 1061 will not apply to such interests so long as each partner’s interest is commensurate with the capital contributed. Additionally, if a partner receives a partnership interest in exchange for managing the partnership’s assets for either no capital contribution or for an amount not commensurate with such partner’s capital contribution, the partner may elect under Section 83(b) to recognize income with respect to such interest. However, the recognition will only except such interest from the definition to the extent such income results in the partner having an interest commensurate with the ratio such interest has to their interest in the partnership. For instance, if a limited partner contributed $100 to a partnership and the managing partner contributed nothing but received a 10% interest in the partnership, the managing partner could avoid the application of Section 1061 as long as he recognized $11 in income. Were he to only recognize $1 under Section 83(b) (based on the uncertainty of future interests,) only one tenth of such interest would not be subject to Section 1061. While this step may help avoid the application of Section 1061, any income recognized under the Section 83(b) election would be ordinary in nature, rather than capital.
If you are acquiring a partnership or LLC interest and are considering making a Section 83(b) election, be sure to discuss with your FGMK tax advisor the costs and benefits, especially if you plan on selling your partnership interest or otherwise receiving substantial gains from your investment within the first three years.