Author: Suzanne Shier
Long-awaited guidance on the tax treatment of partnership (and LLC) interests related to services has been issued in 26 CFR Part 1 [TD 9945] RIN 1545-BO81. For private equity executives assessing compensation arrangements and doing personal wealth planning, there is some good news.
Recall that new Internal Code Section 1061 under the 2017 Tax Cuts and Jobs Act extended the holding period for certain interests to qualify for lower long-term capital gain rate tax treatment from one year to three years, essentially recharacterizing gain for interests held from one to three years as short term gain taxed at ordinary income tax rates (37%), rather than lower long term capital gain tax rates (20%). Proposed regulations issued last summer left many outstanding questions unresolved and provided “unsatisfactory” resolution to others.
For the private equity executive, the now final regulations provide clarity in two areas of particular significance for business and personal wealth planning – the treatment of interests acquired with loan proceeds and the consequences of gifts and transfers at death of interests to family members. Specifically, the exception to the extended holding period rule for capital interests commensurate with contributions will apply to interests acquired with loan proceeds if certain conditions are met. And gifts, sales to grantor trusts for family members, and bequests at death which do not cause recognition of gain will not trigger an acceleration of the taxation of income recharacterized under Section 1061.
- Capital interests acquired with loan proceeds. The extended three-year holding period to qualify for long-term capital gain tax treatment does not apply to qualifying capital interests where the contribution made is commensurate with the interest received. The proposed regulations severely restricted the circumstances in which capital interests acquired with the proceeds of loans made directly or indirectly by another partner, the partnership or a related person could qualify for the capital interest exception. This was particularly problematic for early career executives with limited liquidity relying on such loans to acquire capital interests and a potential barrier to entry in an industry working to increase the diversity of its professionals. Although the final regulations do not remove loan limitations altogether, the good news is that allocations attributable to loans or advances made by another partner (or a related person, other than the partnership) for which the borrower is personally liable will be respected as capital interest allocations. To qualify, the loan or advance must be fully recourse, with no right to reimbursement and not be guaranteed by another person.
- Wealth planning transfers. Lifetime gifts to trusts, sales to grantor trusts, and transfers at death are core aspects of wealth transfer planning and are ordinarily arranged so as not to accelerate income. Planning for lifetime transfers is particularly timely as the current increased federal gift and estate tax exclusion ($11.7 million in 2021) is scheduled to sunset December 31, 2025 (and revert to $5 million, adjusted for inflation). With the Democratic sweep in Washington, the sunset could come sooner and the reduced levels could be as low as those in 2009 – $3.5 million. We just don’t know. But at present, the increased exclusion level is in effect and significant assets may be transferred without any gift tax. But a potential trap for the unwary was that Section 1061 applies to “transfers” and the proposed regulations could have included gifts to family members (outright or in trust), sales to grantor trusts, and bequests at death that do not otherwise trigger income tax, in essence, causing an acceleration of income, not just a future recharacterization. Fortunately, the final regulations make clear that recharacterization only occurs when the owner taxpayer recognizes income in a sale or exchange. Wealth planning transfers that do not otherwise trigger income taxation will not cause an early recharacterization and tax under Section 1061. However, the new family member owner taxpayer will remain subject to Section 1061.
Although we now have clarity and a reprieve, the question is, for how long. Strategic planning with partnership services-related interests is only meaningful when ordinary and capital gain tax rates materially differ. If ordinary income tax rates for high-income individual taxpayers revert to the pre-2017 Tax Act level of 39.6%, as has been proposed, the planning becomes more relevant. However, if, at the same time, capital gain on income above $1 million is taxed as ordinary income, as has also been proposed, the benefit is limited or eliminated altogether. Any such changes will make planning over years where income ebbs and flow more nuanced and managing the timing of income more important.
We work with what we know. And at present, we have clarity regarding both capital interests acquired with loan proceeds and wealth planning transfers. We know the current individual ordinary and capital gain income tax rates and we know the current gift and estate tax exclusion amounts. Planning today can avoid pitfalls tomorrow.