Proposed Regulations Provide Guidance on Taxation of Carried Interests

Alerts / August 18, 2020

On July 31, the IRS and the Treasury Department released long-awaited proposed regulations on the Section 1061 “carried interest” rules. The proposed regulations include extensive definitional and operational rules on the application of Section 1061, but leave important questions unanswered. The proposed regulations also include related amendments to existing regulations under Sections 702, 704 and 1223. As a practical matter, the proposed regulations impose significant reporting and filing obligations and may necessitate amendments to partnership operating agreements. Comments on the proposed regulations are requested by Oct. 5.

A carried interest is an interest in partnership profits that is transferred to a service provider, such as a fund manager, in excess of any contributed capital in exchange for investment- and management-related services. Historically, a carried interest partner could recognize long-term capital gain with respect to the interest by way of partnership allocations or on its sale. In 2017, however, Congress significantly curtailed that tax benefit when it enacted Section 1061 as part of the Tax Cuts and Jobs Act. In particular, Section 1061 extends the applicable long-term capital gain holding period for an “applicable partnership interest,” or API, from one year to three years and recharacterizes certain long-term capital gain as short-term capital gain.

An API is a partnership interest, including a profits interest, held or transferred in connection with the performance of “substantial services” by the taxpayer or a related person in an “applicable trade or business.” The proposed regulations presume that if a partnership interest is transferred in connection with the performance of services, those services are substantial. The proposed regulations offer no guidance on how the presumption might be overcome, including whether any relief is afforded to a person who performs insubstantial services in connection with the receipt of a profits interest. An applicable trade or business generally includes raising or returning capital and either investing in or disposing of specified assets (including securities, commodities, certain rental- or investment-related real estate, and certain partnership interests) or developing specified assets.

A partnership interest that is owned by a corporation is not an API. Initially, some taxpayers took the position that Section 1061 does not apply to S corporation partners. The proposed regulations, however, treat S corporations as passthrough entities and not corporations for this purpose and eliminate the potential for a per se exclusion from Section 1061 for S corporation partners. In a similar vein, the proposed regulations provide that a passive foreign investment company with an effective qualified electing fund election is not treated as a corporation, eliminating another potential per se exclusion.

The definition of an API also does not include certain capital interests in a partnership. The rules for differentiating between an API and a capital interest are complex; as a general matter, the analysis turns on whether an allocation is based on the partners’ capital accounts and whether the API holder is treated differently than nonservice provider partners. Certain partnership interests held by employees of entities that are not engaged in an applicable trade or business and APIs acquired by certain bona fide purchasers are excepted as well. Once a partnership interest is classified as an API, it remains an API until an exception applies (including the bona fide purchaser exception), even if its holder no longer provides services.

The proposed regulations make clear that a holder’s net long-term capital gain with respect to an API, which may be subject to recharacterization, is determined by taking into account both its distributive share of long-term capital gain or loss from the API and its long-term capital gain or loss from the disposition of the API. The holding period for this purpose generally is determined by reference to the owner of the applicable property (i.e., the partnership for a disposition of a partnership asset or the owner of an API for a disposition of the API, though a look-through rule can apply to certain transfers of partnership interests). Long-term capital gain under Section 1231 (relating to certain depreciable property and real property used in a taxpayer’s trade or business) and Section 1256 (relating to certain contracts that are marked-to-market) as well as qualified dividends are excepted from Section 1061 recharacterization.

An acceleration rule applies when an API is transferred (including by way of contribution, distribution, sale or exchange) to certain related persons. A distribution of property with respect to an API generally is not an acceleration event, though the distributee could recognize short-term capital gain on a subsequent sale of the property. Aggregation rules, rules relating to tiered partnership structures, related party rules, and rules for real estate investment trusts and regulated investment companies also are included in the proposed regulations.

Notably, the proposed regulations do not provide rules on “carry waivers” or “carried interest waivers” (generally, waivers of rights to short-term capital gain in exchange for rights to long-term capital gain). The accompanying preamble states, however, that such waivers “may not” be respected and “may be” challenged under partnership tax rules as well as economic substance and substance over form doctrines. This language suggests that such waivers could be respected in some circumstances, but additional guidance would be necessary to understand the scope of any permitted waiver.

The rules in the proposed regulations generally would apply to taxable years beginning on or after the date the rules are published as final regulations in the Federal Register. In the interim, taxpayers may rely on the proposed regulations so long as they apply them consistently and in their entirety. Alternatively, taxpayers may rely on certain transition-related rules for taxable years beginning in 2020 and subsequent taxable years.

Authorship Credit: Morgan W. Holtman and John R. Lehrer II

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