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IRS Releases Long-Awaited Carried Interest Regulations Under Section 1061

The long-awaited regulations under §1061 are finally here, even if only in proposed form. The proposed regulations, released on July 28, 2020, provide some clarity, and are effective for taxable years beginning after final regulations are published, though taxpayers can rely on them beforehand if followed in their entirety and in a consistent manner.

Basics of §1061

Let’s first review the basics of §1061. Section 1061 was added to the tax code as part of the 2017 Tax Cuts and Jobs Act. It takes aim at the taxation of carried interest, and rather than taxing it as ordinary income, §1061 generally requires a three-year holding period (HP) before gain allocated to certain carried interest arrangements can be treated as long-term capital gain (LTCG). LTCG is subject to tax at a maximum rate of 20% (plus the 3.8% net investment income tax, if applicable) instead of the 37% maximum rate (plus the NIIT, if applicable) applicable to short-term capital gain (STCG) and to ordinary income.

Section 1061 applies to applicable partnership interests (APIs) that are directly or indirectly received or held by a taxpayer in connection with the performance of substantial services by the taxpayer (or a related person) in an applicable trade or business (ATB). Generally, these are structured as profits interests for tax purposes. An ATB generally is a trade or business that in whole or in part consists of (i) raising or returning capital or (ii) investing or developing certain assets including securities, commodities, real estate held for rental or investment, and certain derivatives.

Proposed Regulations Under §1061

Now let’s turn to the proposed regulations under §1061. The proposed regulations generally are taxpayer-friendly and consistent with how taxpayers have been interpreting §1061 since enactment. Notable exceptions are the somewhat narrow interpretation given to the exception for capital gain attributable to a manager’s own capital interest and to the introduction of anti-avoidance rules to prevent the avoidance of §1061, including rules relating to the distribution of property with a holding period of three years or less and to the sale of partnership interests.

General Operation of Three-Year Holding Period

The proposed regulations clarify that the three-year HP that invokes §1061 generally is the HP of the partnership that sells the underlying asset (and which issued the API). They also adopt a limited definition of LTCG, excluding LTCG arising under §1231 (relating to property used in a trade or business), the LTCG component (i.e., 60% of total gain) of capital gain under §1256 contracts (relating to futures and other financial contracts), as well as qualified dividend income (QDI) under §1(h)(11). If an investment partnership hold a RIC or a REIT, then the RIC or REIT will need to provide additional information regarding its capital gain dividends to the partnership because the partnership would not otherwise have this asset-level information.

Section 1061 cannot be avoided by having an investment partnership distribute property in kind, as opposed to selling the property and distributing cash. If an API distributes property in kind, then gain from the sale of the distributed property is subject to §1061 unless the property has been held by the partnership and the partner on a combined basis for more than three years. This rule prevents partnerships from distributing property in kind to avoid the three-year HP requirement.

The proposed regulations allow partners that own more than one API, either directly or indirectly through tiered partnerships or other pass-through entities, to combine or net the results of the APIs at the partner level rather than at the partnership level.

Carried Interest Waivers and Deferrals

A carried interest waiver (CIW) allows managers to waive STCG in exchange for a larger share of future LTCG, or to waive gain from investments with an HP of three years or less in exchange for gain with an HP of more than three years. The proposed regulations do not address CIWs but warn that “these and similar arrangements may not be respected and may be challenged.”

Exceptions from §1061

Not surprisingly, the exceptions are generating the greatest interest among taxpayers. While the proposed regulations provide an exception for APIs held by corporations, the exception does not include APIs held by S corporations, which is not surprising given the IRS’s statement in Notice 2018-18 that the term “’corporation’ in §1061(c)(4)(A) does not include an S corporation.” The exception for corporations also does not apply to passive foreign investment companies (PFICs) for which a qualified electing fund (QEF) election has been made. Thus, taxpayers that previously structured their investment in APIs through S corporations and QEFs to avoid §1061 will need to reconsider those structures.

The next big exception relates to “capital interests.” The proposed regulations exclude the portion of a partnership interest that is a capital interest, meaning an interest funded with cash or property but not one funded with debt incurred from or guaranteed by the partnership, another partner in the partnership, or persons related to the partnership or such other partner. The debt-funded exception to the exception narrows the scope of the exception and is intended to address concerns that taxpayers would attempt to avoid §1061 by disguising profits interests as capital interests. The next exception is one for an interest in an investment partnership that is held by a person who is employed by a different entity that is not engaged in an ATB but that provides services to the investment partnership.

There is also an exception for holders that acquire a partnership interest for fair market value in a taxable transaction where they have not been and are not expected to become a service provider to the partnership, and they are not related to any person that is or has provided services to the partnership.

For questions or further assistance, please contact a member of Withum’s Tax Services Group.

Sale of APIs

Sellers of an API generally recognize capital gain or loss, and whether any such capital gain is long-term or short-term depends on the seller’s HP in the API – in other words, there is no look-through rule that determines HP based on the assets inside the partnership. Thus, if a seller’s HP is more than three years, the gain will be taxed at the 20% rate applicable to LTCG; otherwise, it will be subject to a maximum rate of 37%.

There are two exceptions from this general rule. The first exception generally applies a look-through rule on the sale of an API if 80% or more of the assets inside the partnership have a HP of three years or less. The second exception relates to sales of an upper-tier partnership (UTP) that owns an API in a lower-tier partnership (LTP), e.g., on the sale of an interest in a general partner (GP) that owns a carried interest in an investment fund. In this case, if a taxpayer meets the three-year HP for the UTP, but the UTP does not meet the three-year HP for its ownership interest in the LTP, then the HP of the taxpayer’s gain attributable to the LTP is determined by reference to UTP’s HP in LTP, and the gain would be treated as STCG.

The proposed regulations also accelerate and recast gain as STCG on sales to certain related persons, including family members and colleagues. Section 1061(d) generally triggers STCG if a taxpayer directly or indirectly transfers an API to (i) his or her spouse, children, grandchildren or parents, (ii) a person who has performed services to the partnership within the current calendar year or the preceding three calendar years, or (iii) a pass-through entity to the extent a person described above directly or indirectly owns an interest in such entity. The amount of STCG is equal to the excess of (1) the net LTCG from assets held for three years or less that would have been allocated to the transferor partner upon a hypothetical liquidation of the partnership, over (2) any amount treated as STCG under §1061. The proposed regulations also would require gain to be recognized on the above transfers even if the transaction otherwise would not be taxable, except for contributions of an API to another partnership under §721.

Compliance

The partner holding an API is the person that must comply with §1061 on its federal income tax return, but it will be able to do so only if the partnership provides the necessary information. Thus, the proposed regulations effectively require investment partnerships to track gain and HPs for assets held for more than three years and for assets held for three years or less associated with APIs.

There are also rules governing compliance for interests held through multiple tiers of investments. An upper-tier entity must request information from a lower-tier entity by the later of (i) the 30th day after the close of the calendar year or (ii) 14 days of receiving a request for information. The lower-tier entity must respond by the due date of its tax return (including extensions).

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