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<p>On Jan. 19, 2021, the Internal Revenue Service and the Treasury Department published final regulations on the Section 1061 “carried interest” rules (T.D. 9945). The final regulations generally adopt proposed regulations issued in July 2020 (<a href="https://www.bakerlaw.com/alerts/proposed-regulations-provide-guidance-on-taxation-of-carried-interests">please see our alert from Aug. 18, 2020</a>) but make significant changes to (i) the exception for capital interests, (ii) the look-through rule that applies to certain dispositions of partnership interests and (iii) the rule for non-recognition transfers to certain related persons. While the new rules generally are taxpayer-favorable, they are not without uncertainty.</p>  <h5>Background</h5>  <p>A carried interest is an interest in partnership profits that is transferred to a service provider, such as a fund manager, in exchange for investment- and management-related services. Section 1061 extends the applicable long-term capital gain holding period for an “applicable partnership interest” (API) from one year to three years. 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.” 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. Section 1061 does not apply to capital interests, 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.</p>  <h5><span style="color:#59315f">Summary of Significant Changes in Final Regulations</span></h5>  <h5>Capital Interest Exception</h5>  <p>The definition of API does not include certain capital interests in a partnership, and Section 1061 does not apply to gain allocated with respect to those interests. Under the proposed regulations, an allocation to an API holder qualifies for the capital interest exception so long as it is made in the “same manner” as allocations to certain unrelated non-service provider partners (generally non-service provider partners that contributed 5 percent or more of total contributed capital). An allocation generally satisfies the “same manner” requirement if it is based on the partners’ relative capital accounts and there are no differences in terms, priority, risk, rate of return and distribution rights. Commenters criticized the rules’ rigidity and noted that the capital interest exception would not apply to many common business arrangements, including, for example, situations in which allocations are determined on an investment-by-investment basis, based on different classes of partnership interests that have different rights and priorities or determined based on target capital accounts.</p>  <p>The final regulations offer a more flexible approach; an allocation to an API holder satisfies the capital interest exception if it is determined and calculated in a “similar manner” as allocations with respect to capital interests held by unrelated non-service partners who have made significant capital contributions (the final regulations retain the 5 percent of contributed capital requirement). The final regulations further provide that there must be reasonable consistency in allocation and distribution rights as between the API holder (with respect to its capital interest) and the unrelated non-service partners, and that the “similar manner” test can be applied on an investment-by-investment or a class-by-class basis. The final regulations confirm that an API holder’s interest can qualify as a capital interest even if the holder is entitled to certain tax distributions and/or does not share in management fee expense or API-related items. Gain allocated to an API holder but retained by and reinvested in the partnership is treated as a contribution in exchange for a capital interest, which may give rise to capital interest allocations.</p>  <p>Like the proposed regulations, the final regulations require that allocations with respect to capital interests be clearly identified and distinguished from API-related allocations in a partnership’s operating agreement and books and records. It is important that funds and similar partnerships review their operating agreements and their books and records, and update as necessary.</p>  <p>The final regulations also offer flexibility for capital interests acquired with loan proceeds. In contrast to the proposed regulations, which provide that an API holder’s capital account does not include amounts attributable to a loan from a partner, the partnership or certain related persons (except to the extent the loan is repaid), the final regulations generally treat interests acquired with such loan proceeds as capital interests so long as the API holder is personally liable for the loan (or as the loan is repaid). The loan must be recourse to the API holder, without any guarantee or right to reimbursement. While the final regulations’ approach is a welcome change to the proposed regulations, it is not clear it will cover lending arrangements common to fund structures.</p>  <h5>Look-Through Rule for Certain Dispositions of Partnership Interests</h5>  <p>Under the proposed regulations, a look-though rule applies to a disposition of an API that has been held for more than three years if the “substantially all test” is satisfied. The substantially all test is based on a hypothetical disposition of partnership assets; the test is satisfied if at least 80 percent of the assets (determined based on fair market value) would produce capital gain or loss that would be characterized as short term under Section 1061. In the case of tiered partnership structures, the look-through rule is applied by reference to characteristics of the lower tiers. Commenters noted that the substantially all test could be burdensome in application, especially in the context of tiered partnerships.</p>  <p>The final regulations replace the substantially all test with a more subjective rule that applies in two situations. First, the look-through rule applies if an API would have a holding period of three years or less if any time prior to the date that an unrelated non-service provider is obligated to contribute substantial money or property (generally having a value of at least 5 percent of total contributed capital) to the partnership is ignored. The practical effect of this rule is that an API holder may be required to hold its API more than three years to realize long-term capital gain (this could happen, for example, if a fund has a long capital commitment period). The look-through rule also applies if a transaction or series of transactions has a principal purpose of avoiding recharacterization under Section 1061. The final regulations provide limited guidance on the look-through rule, and the “principal purpose” portion of the rule in particular could have broad application.</p>  <h5>Non-recognition Transfers to Certain Related Persons</h5>  <p>The proposed regulations provide that if an API holder transfers its API to a “[S]ection 1061(d) related person,” including in a non-recognition transaction, the holder could recognize short-term capital gain, generally determined on a look-through basis. “Section 1061(d) related person include family members, colleagues and passthrough entities if a family member or colleague owns an interest therein. Among other issues, commenters questioned whether it was appropriate to accelerate gain in a non-recognition context and how the rule applied to gifts and other estate-planning transfers. The final regulations reverse course and provide that acceleration does not apply to nontaxable transfers. In other words, an API holder that transfers its API in a non-recognition transaction, including a gift or non-recognition transfer to a trust or other entity, will not recognize gain under Section 1061 (the API remains subject to Section 1061 in the transferee’s hands). This is a significant taxpayer-favorable change. The look-through rule continues to apply to taxable transfers to Section 1061(d)-related persons.</p>  <h5>Effective Date</h5>  <p>The final regulations generally apply to taxable years beginning on or after Jan. 19, 2021. Note, however, that final regulations retain the rule that S corporations are passthrough entities (and not corporations) for purposes of Section 1061, and this rule applies retroactively to taxable years beginning after Dec. 31, 2017. API holders can elect to apply the final regulations to taxable years beginning after Dec. 31, 2017, as long as they apply them consistently and in their entirety.</p>  <p><em>Authorship Credit: Morgan W. Holtman and Edward G. Ptaszek Jr.</em></p>




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Morgan W. Holtman

Transactional Tax

Carried Interest Update: Final Regulations Provide Taxpayer-Favorable Rules, but Unanswered Questions Linger

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