The IRS issued final regulations under IRC Section 1061 on January 7, 2021 with some notable updates made in response to comments from the proposed regulations published on August 14, 2020.
IRC Section 1061 was added to the tax code under the 2017 Tax Cuts and Jobs Act. The statute refers to partnership interests held in connection with performance of services. It was designed to address the long-term capital gain tax treatment from which service providers such as hedge fund, private equity and venture capital fund managers benefited. The rule requires a holding period of three years rather than one year to qualify for the lower long-term capital gain tax rate for applicable partnership interests (API).
Capital Interest Exception
While managers may be granted a profits interest that qualifies as an API, they may also contribute capital to the partnership or reinvest previously earned amounts. For those amounts, the proposed and final regulations provided for a capital interest exception. The final regulations modified the wording with regard to the application of that exception. The proposed regulations provided for the exception to apply when allocations were made in the same manner as capital interests held by unrelated non-service partners. Revising the wording in the final regulations allows for the capital exception to apply even in circumstances where the service provider’s account is not charged incentive or a management fee, has different withdrawal rights or participation options with respect to new issues. The capital interest allocations to an API holder still uses the five percent threshold to define a significant capital account balance of an unrelated non-service partner for the similar manner test.
The final regulations also reworked the treatment of a capital interest that is acquired with loan proceeds. As long as the loan is not guaranteed by another party, the capital interest would be respected for purposes of Sec. 1061. For amounts contributed via a loan guaranteed by another partner or partnership, repayments of the loan are included in capital accounts as paid.
Disposition of APIs
The proposed regulations initially provided a lookthrough rule applicable to the disposition of an API. The lookthrough rule was designed to apply to dispositions of an API with a holding period greater than three years but where eighty percent or more of the assets of the partnership would produce capital gain with holding period of less than three years. In response to comments on the difficulty to implement the lookthrough in tiered structures, the IRS adjusted the rule to only be applied in limited situations as an anti-abuse rule.
Transfers of APIs to Related Persons
The final regulations provide a welcome change to the treatment of transfers under Section 1061(d). The proposed regulations contemplated acceleration of gain upon certain transfers to related persons. Thankfully due to comments and feedback received on the proposed regulations, the final regulations abandoned the acceleration component. Transfers to related persons of an API will be subject to recharacterization for realized gains related to assets held less than three years. However, if a transfer is otherwise a nontaxable transfer, it will not become a taxable event under this section.
Effective Dates
These final regulations are generally effective for the 2022 tax year. There are two provisions within the final regulations that are effective earlier. IRC Reg 1.1061-3 provides for exceptions to the definition of an API (Applicable Partnership Interest). An S corporation for which an election under section 1362(a) is in effect is not treated as a corporation for purposes of defining an API. This provision of the regulation is effective as of December 31, 2017. A Passive Foreign Investment Company (PFIC) with a qualifying electing fund election in effect does not qualify as a corporation for purposes of defining an API. This rule is effective as of August 14, 2020 when the proposed regulations were published.
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