Articles by: Richey May, Jan 11, 2023
What You Need To Know About Amending The Tax Language In Your Partnership Agreements
General partners and private fund principals, take note. If you receive a performance allocation or carried interest from a pooled investment vehicle, you’ll want to have your attorney and administrator take a look at your partnership agreements before March 15, 2023.
Why GPs and fund principals, and why now? It has everything to do with a little something called the 1061 rule and its potential to affect your ability to obtain long-term treatment on capital gains or losses based on the tax language in your partnership agreement. And since we’re talking taxes, the business tax deadline of March 15th applies.
So what’s the 1061 rule? It’s a new regulation created by the Tax Cuts and Jobs Act of 2017, which changed U.S. federal income tax law to reclassify certain long-term capital gains earned on performance allocations as short-term capital gains. The new rule requires a three-year holding period on assets instead of the typical one-year holding period.
What’s the upshot? The rules around regulation 1061 are complex, but here’s the skinny: If you have an applicable partnership interest (API) in a private fund and want to preserve your preferred tax treatment on invested capital and reinvested gains, you have a vested interest in heeding this rule.
Note: The new regulation defines an API as “anyone having an interest in a partnership transferred to or held by a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.”
Two reasons to add protective tax language to your partnership agreement:
- Allocations made to an API holder that don’t meet the requirements of the final regulations will not be considered capital interest allocations.
- The reallocation of long-term to short-term will not apply to capital interest allocations that meet the regulations or reinvested gains in which the performance allocation has already been subject to a tax.
What do I need to do? Have your attorney and administrator ensure that the partnership agreement clearly demonstrates the division between investment property and the fund’s performance allocation to the API holder. They’ll need to make sure both the partnership agreement and the books and records state in consistent language that the allocation and its provisions are separate and apart from the allocations made to the API holder.
Note: The final regulations do not include a rule that would grandfather existing partnership agreements or provide a transition period for partnerships to update their agreements.
Key takeaways: If you want to be in compliance for the 2022 tax year (and oh yes, you do), talk to your attorney by March 15th about the tax language in your partnership agreement. And check in with your administrator to ensure they’re treating it correctly.