In anticipation of the March 15, 2023, filing deadline for partnership tax returns, we recommend that clients assess whether their fund partnership agreements are current regarding the implications of Section 1061 of the Internal Revenue Code (Section 1061). Section 1061 largely took effect on January 1, 2022, and was introduced as part of the 2017 Tax Cuts and Jobs Act in an effort to limit the favorable tax treatment afforded to some recipients of performance allocations or carried interest.
Under Section 1061, the holding period for certain applicable partnership interests (APIs) acquired in connection with the performance of substantial services was extended from one year to three years. This generally means that if a fund’s general partner holds an API for less than three years—or the API relates to an asset that has been held for less than three years—any resulting capital gains may be subject to recharacterization as short-term capital gains. Notably, however, the three-year extended holding period does not apply to capital gains and losses allocated to a holder of a capital interest when the right to share in profits is commensurate with the holder’s capital contributions (Capital Interest). In other words, Section 1061 generally does not apply to a general partner’s capital contributions and reinvested gains.
As a result, we recommend that fund general partners confirm their fund partnership agreements create separate accounts for tracking Capital Interests and performance allocations or carried interest. Additionally, fund general partners should confirm with their fund administrators that separate accounts for Capital Interests and performance allocations or carried interest are being maintained in the fund’s books and records. Absent such separate tracking, fund general partners run the risk of Section 1061 applying to their entire capital account regardless of the source of gains and losses. Please note that any such updates to fund partnership agreements should be made prior to March 15, 2023.
We encourage you to reach out to us if you would like for us to review your fund partnership agreement to assess whether it needs to be amended to address Section 1061. If you would like our assistance, feel free to reach out directly to Kevin Cott at kevin@cottlawgroup.com.
