As Spring approaches, the March 15, 2023 U.S. Internal Revenue Service (“IRS”) deadline for partnership tax filings draws near and Cole-Frieman & Mallon LLP advises clients to consider whether their investment funds’ partnership agreements conform to recent changes to the U.S. Internal Revenue Code (the “Code”) and related IRS regulations (the “Final Regulations”) and, if not, whether revisions are necessary. The IRS is requiring any such revisions to fund partnership agreements be made before March 15, 2023.
Following the enactment of the Tax Cuts and Jobs Act of 2017, newly created Section 1061 of the Code and related provisions of the Final Regulations generally recharacterize long-term capital gains that general partners receive with respect to their partnership interests as short-term capital gains if those partnership interests are held for less than three years.
This unfavorable recharacterization generally applies to performance allocations and carried interest distributions, but it generally does not apply to gains that come from general partners’ (1) capital contributions or (2) reinvested gains (the “Capital Interest Exception”).
However, to take advantage of the Capital Interest Exception, a fund’s partnership agreement and its books and records must reflect a clear division between allocations covered by the Capital Interest Exception and other allocations, such as performance allocations and carried interest distributions.
While many fund partnership agreements may already reflect this clear division, CFM advises recipients of performance allocations and carried interest distributions to consider whether additional language such as the following would help further crystalize the division:
In accordance with Regulation Section 1.1061-3(c)(3)(ii)(B), the Fund shall calculate separate allocations attributable to the General Partner’s right to receive the [Performance Allocation/Carried Interest], any other entitlements that are not commensurate with capital contributed to the Fund, and any allocations to the Partners that are commensurate with capital contributed to the Fund (in each case, within the meaning of Regulation Section 1.1061-3(c)(3) and as reasonably determined by the General Partner) and will consistently reflect each such allocation in its books and records.
Adding language such as the above generally would not adversely affect fund investors, and thus for many fund partnership agreements, this language can be implemented without investor consent. You should review the amendment provisions in your partnership agreements to determine whether investor consent is necessary.
In addition to making any necessary amendments to a fund’s partnership agreement, a fund manager should also contact their fund administrator to ensure that the fund’s books and records will be maintained in a manner that clearly demonstrates the division between allocations covered by the Capital Interest Exception and other allocations.
Please feel free to contact us with any questions you may have on this topic or if you would like assistance in reviewing your fund’s partnership agreement for compliance with this issue.
