Navigating The Split-Holding-Period Rules For Partnership Interests

Steven Z. Hodaszy (Robert Morris; Google Scholar), Navigating the Split-Holding-Period Rules for Partnership Interests, 77 Tax Law. __ (2024):

When a partner contributes a capital asset or a section 1231 asset to her partnership in exchange for her interest in the partnership, section 1223(1) provides that her holding period for the contributed asset tacks—i.e., is added to—her holding period for the partnership interest. This ensures that, if the partner sells her partnership interest within one year, any deferred long-term capital gain on the contributed asset retains its long-term character when the partner recognizes it at the time of the sale. When a partner contributes more than one asset to her partnership and receives only a portion of her partnership interest in exchange for a contributed capital asset or section 1231 asset, there needs to be a mechanism for determining the portion of the partner’s holding period for her interest to which the partner’s holding period for the contributed capital or section 1231 asset tacks. The split-holding-period rules in regulation § 1.1223-3 provide that mechanism.

Unfortunately, although the split-holding-rules serve a necessary purpose, the current formulation of regulation § 1.1223-3 is both needlessly complex and substantially flawed. Much of the complexity comes from “special” rules in paragraphs (b)(4) and (e) of the regulation to disregard a partner’s contribution of section 751 assets and to bifurcate contributed section 1231 assets with built-in section 1245 recapture income, respectively. The rules concerning treatment of section 1245 recapture income have been a particular source of confusion for some commentators.

The most troubling flaw relates to the formula in regulation § 1.1223-3(b)(1) for dividing a partner’s holding period for her partnership interest. Under that formula, when a partner sells her partnership interest within one year, a portion of her capital gain attributable to partnership assets other than the capital or section 1231 asset she contributed, is often treated as long-term. Because that portion of the partner’s gain does not derive from the partner’s continued investment in the contributed asset, it should instead be treated as short-term capital gain and taxed at the partner’s marginal rate for ordinary income. Given the preferential long-term capital gain rates for individual taxpayers, this flaw in the regulation often provides an unwarranted tax break for short-term sellers of partnership interests.

This article provides a detailed review of the split-holding-period rules in regulation § 1.1223-3, to make sense out of the confusion they often cause. Then, the article explains precisely how the rules create an unjustified tax windfall for a partner who sells her partnership interest within one year after acquiring the interest from the partnership.

Finally, this article proposes specific textual revisions to regulation § 1.1223-3, which would eliminate the regulation’s flaws and reduce its complexity. If the article’s recommended changes to regulation § 1.1223-3 were made, the split-holding-period rules would continue to serve their intended purpose of preserving the character of deferred long-term capital gain on an asset that a partner contributes to her partnership. At the same time, however, the rules would no longer be susceptible to misuse, to convert other gain on a short-term sale of a partnership interest to long-term capital gain.