The Tax Cuts and Jobs Act (the Act) became law approximately six months ago, significantly transforming how we compute federal income taxes. In this edition of the Tax Reform Progress Report, we focus on a handful of topics affected by the Act, including carried interests, retirement plan loans and Roth recharacterizations. Also discussed is new guidance on the section 965 transition tax.
In this issue:
- Critical issues regarding carried interests
- Rollover of retirement plan loans
- Roth recharacterization
- Limited late election and penalty relief for taxpayers subject to the section 965 transition tax
In general, the receipt of a capital interest for services provided to a partnership results in taxable compensation to the recipient. However, a safe harbor rule allows that the receipt of a profits interest in exchange for services is not a taxable event if the holder is entitled to share only in gains and profits generated after the date of issuance (and certain other requirements are met). In the context of hedge funds, private equity funds, real estate funds, etc., a profits interest granted to the fund manager is often known as a “carried interest.”
The TCJA added section 1061, which recharacterizes certain income attributable to carried interests as short-term capital gain (STCG), rather than long-term capital gain (LTCG). Section 1061(a) provides that a three-year holding period is now required in the case of certain net LTCG with respect to any “applicable partnership interest” (API) held by the taxpayer. Capital gains that do not meet the three-year holding period will be treated as STCG and, therefore, taxed at higher ordinary rates.
The new rules apply to API held or received in connection with the performance of services in any “applicable trade or business.” An applicable trade or business means any activity that consists in whole or in part of the following: (1) raising or returning capital and either (2a) investing in (or disposing of) “specified assets” (or identifying specified assets for investing or disposition), or (2b) developing specified assets. Specified assets means securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to such securities, commodities, real estate, cash or cash equivalents as well as an interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing.
In this article, we analyze two questions where we are awaiting guidance:
- Does the three-year holding period apply to 1) the applicable partnership interest, 2) a sale of the underlying assets in the partnership, or 3) both?
- Are section 1231 gains included in the definition of “net long-term capital gain” for purposes of section 1061?
Three-year holding period
Section 1061(a) refers to net LTCG “with respect to” APIs; however, this language is vague. It is not clear from the statute if the three-year holding period applies to sales of assets held (directly or indirectly) by the partnership, sales of partnership interests or both. Section 1061 treats gains that fail the three-year test as STCG. Consider the following example:
- 2017: Partnership formed, A gets a carried interest for providing substantial services (basically, a promote interest), other investors contribute cash. The interest is an API.
- 2018: Partnership sells an asset held for more than one year but less than three years at a gain. The gain is LTCG for the investors — the investors do not hold APIs so their gain is not subject to section 1061. However, A holds an API and fails the three-year holding period for both the partnership interest and the underlying assets. Therefore, A’s share of the gain is treated as STCG and taxed at higher ordinary rates.
- 2018 variation: Assume the same facts as above, except the underlying asset has been held by the partnership for more than three years. The gain is still LTCG to the investors. However, since A has held the API for less than three years, is A’s share of the gain now treated as STCG?
Discussion: Some commentators are taking the position that, since the partnership has held the asset for more than three years, the gain is not subject to recharacterization. This position appears to be based on an application of Rev. Rul. 68-79, which, while still good law, was not drafted with the new TCJA provision in mind. Under this guidance, the holding period of the underlying asset in the hands of the partnership (and not the holding period of the partnership interest) is what determines whether the gain is LTCG or STCG.
- Rev. Rul. 68-79 addressed a situation where a partnership recognized an LTCG, but had a partner who recently acquired his partnership interest. The issue was whether that partner had an LTCG since his partnership interest was a short-term hold. Citing section 702(b), the ruling concluded that the character of any item of income, gain, etc., included in a partner’s distributive share is determined at the partnership level. In other words, the holding period of the underlying asset in the hands of the partnership determines whether the gain is long-term versus short-term, not the holding period of the partnership interest.
- Rev. Rul. 68-79 is still good law, but it is now 50 years old and it was not drafted with section 1061 in mind. Notably, section 1061 functions at the taxpayer/partner level, i.e., the recharacterization happens at the taxpayer level, not the partnership level. So in this regard, section 1061 already overrides the conclusion in Rev. Rul.68-79 for assets held by the partnership for less than three years.
- The critical question is the meaning of the phrase “with respect to such interests” as contained in section 1061(a)(1). Conceivably, this language could be interpreted to put carried interests outside the scope of Rev. Rul. 68-79. If that is the case, any gains allocated to an API held for less than three years would be treated as STCG, regardless of the partnership’s holding period of the underlying assets.
At this time, based on Rev. Rul. 68-79, we believe taxpayers who have held APIs for less than three years have filing position to treat gains recognized by the partnership for assets held more than three years as LTCG not subject to this new recharacterization under section 1061. However, taxpayers should be mindful that guidance from Treasury is pending on section 1061 and such guidance could reach a different conclusion.
Will section 1231 gains be recharacterized under section 1061?
- Section 1231 assets include depreciable assets used in a trade or business and real property used in a trade or business. Section 1231 gains are taxed at the capital gain rate, but the underlying assets are not capital assets under the Code. Section 1231 gains commonly arise in real estate. For example, gain on the sale of a rental property held more than one year generally is section 1231 gain whereas gain resulting from the sale of an investment asset, such as a stock, is not section 1231 gain.
- Based on a literal reading of the Code, section 1061 does not encompass section 1231 gains. As noted above, section 1231 assets are not capital assets, and section 1061 does not cross-reference section 1231. However, under section 1061(c) the term “specified assets” includes real estate held for investment or rental (emphasis added). Since rental real estate is, by definition, property used in a trade or business, any gain from its sale would be a section 1231 gain. Consequently, there is a drafting tension within the Code section itself.
- Arguably, this tension in the Code does present a potential loophole from treating section 1231 gains from the provisions of section 1061 as related to API’s and related STCG treatment.
Based on a strict reading of section 1061, we believe taxpayers have a position to treat section 1231 gains recognized by the partnership as exempt from recharacterization under section 1061 from LTCG to STCG. However, as with the three-year holding period issue discussed above, we advise taxpayers to be mindful of pending guidance from Treasury that could issue regulations to the contrary or that this result could be changed if a technical corrections bill is enacted by Congress.
Certain retirement plan participants now have an extended period to pay off plan loans under the TCJA. Participants who have a loan outstanding at the time of plan termination or severance from employment have a longer timeframe to pay the amount of an outstanding plan loan to another qualified plan or an IRA in order to accomplish a tax-free rollover of the loan offset amount.
Generally, a plan loan offset occurs when the terms of the plan accelerate repayment of the loan upon severance from employment, resulting in the participant’s account balance in the plan reduced by the amount of the outstanding loan. This unpaid balance reduces the participant’s account balance and is known as the plan loan offset amount. These are treated as an actual distribution reported on Form 1099-R, are taxable to the participant and are subject to the 10 percent additional income tax on early distributions, unless an exception applies.
A plan loan offset amount is also an eligible rollover distribution. However, prior to the TCJA, if a participant wanted to defer taxes on that unpaid loan balance, the participant had 60 days to roll the cash value to another eligible retirement plan or IRA. The TCJA extended this deadline to the due date for the participant’s tax return, including extensions, for the year in which the loan offset occurred. While this change does not affect the operation of the plan, from a participant’s perspective, it provides more time to accumulate necessary funds to complete a tax-deferred rollover.
The plan loan offset provisions apply to amounts treated as distributed in tax years beginning after Dec. 31, 2017.
The TCJA eliminated the ability to recharacterize Roth conversions for taxable years after 2017.
An IRA is not subject to income tax until assets are distributed. However, since assets in a Roth IRA are subject to income tax when contributed, neither the assets nor the investment gains are subject to income tax upon distribution.
Converting a traditional IRA to a Roth IRA provides the taxpayer with the opportunity to hedge against future higher income tax rates. At the time of the conversion to the Roth IRA, the taxpayer pays income tax on the value of the account. Since future increases in value are not subject to income tax, the taxpayer has tax-free withdrawals in retirement.
A Roth recharacterization reverses the conversion from a traditional IRA to a Roth IRA. There are several reasons a taxpayer may consider this:
- The value of investments in the converted Roth IRA has declined since the date of the conversion
- Higher-than-expected taxable income and/or the additional income from the Roth IRA conversion resulted in the taxpayer moving into a higher federal income tax bracket
- Taxable income in retirement will likely be lower than expected, reducing the potential benefits of a Roth IRA’s tax-free distributions
- Not enough cash on hand to pay the taxes resulting from the conversion
Although a Roth conversion can no longer be reversed, a taxpayer may contribute to a Roth IRA and, before the due date for filing the taxpayer’s income tax return, convert it as a contribution to a traditional IRA. In addition, a taxpayer may still contribute to a traditional IRA and convert the traditional IRA to a Roth IRA; however, the taxpayer cannot later unwind the conversion through a recharacterization.
The IRS issued frequently asked questions (FAQ) to clarify the effective date prohibiting a taxpayer from recharacterizing a Roth conversion. The FAQ provides that a Roth IRA conversion made in 2017 may be recharacterized as a contribution to a traditional IRA if the recharacterization is made by Oct. 15, 2018. A Roth IRA conversion made on or after Jan. 1, 2018, cannot be recharacterized.
The FAQ confirms that elimination of Roth recharacterization applies to a conversion from a traditional IRA, SEP or SIMPLE to a Roth IRA. In addition, the FAQ provides that the TCJA prohibits recharacterizing amounts rolled over to a Roth IRA from other retirement plans, such as 401(k) or 403(b) plans.
Updated FAQ provides limited late election and penalty relief for certain taxpayers subject to the IRC section 965 transition tax
Over the last couple of months, the IRS has released guidance in the form of an FAQ regarding the repatriation tax. Most recently, on June 4, 2018, the IRS issued additional updates to the FAQ announcing that it will waive certain late-payment penalties relating to the IRC section 965 transition tax as well as provide additional guidance regarding due dates for relevant elections.
The FAQ was intended to provide additional guidance on the section 965 transition tax which requires U.S. shareholders to pay a one-time tax on the previously untaxed foreign post-1986 earnings and profits (E&P) of a specified foreign corporation (SFC).
The IRS introduced three new Q&As that, in general, indicate the following:
- In some cases, the IRS will waive the estimated tax penalty for taxpayers subject to the transition tax who improperly attempted to apply a 2017 calculated overpayment to their 2018 estimated tax, if all required estimated tax payments were made before the due date for the second required estimated tax installment, i.e., June 15, 2018, for calendar-year taxpayers. This relief applies only to taxpayers whose first required installment for 2018 was due on or before April 18, 2018. (Q&A 15)
Observation: We believe the latest Q&A reinforces the IRS’ intention to apply a 2017 tax-year overpayment to successive installments of transition tax liability not yet otherwise due for those taxpayers electing to pay in eight annual installments. It remains to be seen whether any procedural challenges might be raised and/or the IRS might ultimately reconsider its “confiscatory” approach to application of overpayments in this regard.
- Individual taxpayers electing to pay the transition tax in eight annual installments and were underpaid at the due date of the first required installment (i.e., April 18, 2018, for calendar-year taxpayers), the late-payment penalty will be waived if the installment is paid in full by the due date for the second required installment (i.e., April 15, 2019, for calendar-year taxpayers). Absent this relief, a taxpayer’s remaining installments over the eight-year period would have become due immediately. This relief is only available if the individual’s total transition tax liability is less than $1 million. Interest will still be due. Later deadlines apply to certain individuals who live and work outside the United States. (Q&A 16)
Observation: Non-individual and individual taxpayers with a total transition tax liability of $1 million or more would not appear covered under this relief. More importantly, this latest Q&A perhaps signals the IRS’ intention to accelerate the full transition tax liability for taxpayers (not covered under this relief) otherwise looking to elect installment treatment but are underpaid as to the first required annual installment and had a penalty assessed and not successfully abated. It will be extremely important for you to work with your tax advisor if you face a potential acceleration event.
- Individuals who have already filed a 2017 return without electing to pay the transition tax in eight annual installments can still make the election by filing a 2017 Form 1040X with the IRS. The amended Form 1040 generally must be filed by Oct. 15, 2018. (Q&A 17)
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