On July 31, 2020, the U.S. Department of Treasury and the IRS released proposed regulations (the Proposed Regulations) related to the so-called “carried interest” rules (i.e., rules applicable to certain partnership interests received by a taxpayer in connection with the performance of substantial services) enacted under Section 1061 of the Internal Revenue Code (the Code). Section 1061 was added to the Code in connection with the Tax Cuts and Jobs Act of 2017 to re-characterize what otherwise would be long-term capital gains with respect to certain carried interests as short-term capital gains unless specific holding period requirements are satisfied. Specifically, Section 1061 extends the holding period required for long-term capital gain treatment from greater than one year to greater than three years with respect to certain carried interests. However, there were a number of fundamental questions concerning the application of the Section 1061. The Proposed Regulations add some much needed clarification and guidance and generally affect investment funds (including private equity, venture capital, real estate, and other alternative asset funds) and the managers and general partners of such funds.
Generally, Section 1061 is limited in application to taxpayers that hold applicable partnership interests (APIs). For purposes of Section 1061, an API is one that is received by the taxpayer in exchange for substantial services rendered with respect to an applicable trade or business (ATB). An ATB is an activity conducted on a regular, continuous, and substantial basis and consists of raising or returning capital and either investing in or developing specified assets (e.g., securities, real estate, commodities, and interests in partnerships to the extent of the partnership’s interest in any specified assets). There are exceptions to partnership interests being treated as APIs under Section 1061 for interests held by corporations (the IRS released Notice 2018-18 to clarify this exception should not apply to S corporations) and certain capital interests.
Section 1061 imposes a three-year holding period requirement in order to receive long-term capital gains treatment with respect to any partnership interest that is an API.
Highlights of Proposed Regulations
As mentioned above, one exception to API treatment is to hold the interests in a corporation. Thus, many practitioners hoped they could hold partnership interests that would otherwise be treated as APIs through an S corporation in order to circumvent application of Section 1061 without adding a layer of corporate tax.
The Proposed Regulations clarify that the Section 1061 exception for APIs held by corporations does not apply to S corporations, consistent with previously issued IRS Notice 2018-18. The Proposed Regulations further excluded certain passive foreign investment corporations (PFICs) from being able to take advantage of the corporation exception to API treatment under Section 1061.
It is not entirely clear whether Treasury has the authority to exclude S corporations from the definition of “corporation” under Section 1061 and, in this respect, we anticipate pushback from taxpayers and practitioners prior to finalization of the Proposed Regulations.
Relevant Holding Period
A significant uncertainty under Section 1061 was the relevant holding period to be applied for determining long-term capital gain treatment on the sale of property by a partnership – is it the holding period of the partner's API or the holding period of the underlying partnership's assets? For example, if a partner holds an API in a partnership for one year and the partnership sells securities that it has held for over three years, is the partner eligible for long-term capital gains treatment on the sale of the securities? The Proposed Regulations confirm, consistent with historical tax principles, that the holding period of the party that sells the property (i.e., the partnership in the prior example) is the relevant holding period for purposes of determining whether Section 1061 applies in recharacterizing any of the gain from the sale as short-term capital gain. Therefore, in the prior example, the partner would receive long-term capital gains treatment on its allocable share of gain from the sale of the securities by the partnership even though it had held its API for less than three years.
Generally, the holding period of a partner's API determines the treatment on the sale of the API, however, there is a limited exception that requires looking through to the holding period of the underlying partnership assets for partnerships that meet the so-called Substantially All Test. The Substantially All Test is met if 80% or more of the assets of the partnership in which the API is held (excluding certain net working capital assets and inventory), based on fair market value, are capital assets (excluding items excluded from application of Section 1061, as discussed below) that have a holding period of three years or less. The Substantially All Test is particularly relevant to any fund manager seeking to monetize its API in a fund that primarily holds capital assets for less than three years.
Further, if a partnership distributes capital assets with respect to an API, the distributee must hold such property for three years (inclusive of the partnership’s holding period of such property) in order to obtain long-term capital gains treatment upon any subsequent disposition of such property.
Finally, the Proposed Regulations did not address whether a new holding period is required as a result of a fund contributing additional capital to a portfolio company (for which the fund receives no additional stock) to be used in an add-on acquisition. This remains an area of uncertainty.
Significant Exclusion for Real Estate
The Proposed Regulations confirm that gains with respect to the following items are not subject to Section 1061 and its limitations: Section 1231 gains (i.e., depreciable property used in a trade or business); Section 1256 gains (i.e., regulated futures and certain other contracts); qualified dividends receiving preferential rates under Section 1(h)(11); and any other capital gains characterized as long or short term without regard to the Section 1222 holding period rules (e.g., certain straddles under Section 1092).
The exclusion of Section 1231 property significantly reduces the impact of Section 1061 to real estate funds, which is good news for the real estate industry.
- REITS and RIC Capital Gain Dividends: The Proposed Regulations provide that capital gain dividends from real estate investment trusts (REITs) and regulated investment companies (RIC) receive long-term capital gains treatment so long as the capital gain dividend is attributable to capital assets held more than three years or assets excluded from the application of Section 1061.
- Bona Fide Purchaser Exception: An API does not include an interest in a partnership that would be treated as an API but is held by a bona fide purchaser of the interest who does not currently and has never provided services to the partnership and who is not related to a person who provides services currently or has provided services to the partnership in the past.
- Carry Waivers: The preamble to the Proposed Regulations states that arrangements commonly referred to as carried waivers, whereby the holder of an API waives its right to receive income from applicable assets that do not meet the three-year holding period requirement in exchange for a corresponding increase in its share of income from applicable assets that do meet the three-year holding period, may not be respected and may be challenged by the IRS.
- Installment Sale Gain: Installment sale gains recognized after enactment of Section 1061 are subject to the three-year holding period requirements, determined on the date of the sale, even if the sale was made prior to enactment of Section 1061 (e.g., in 2017).
- Computation of Section 1061 Amounts: The Proposed Regulations provide detailed mechanics to determine the amount of partner allocations that may be subject to Section 1061 and the amount that may be attributable to capital interests and therefore excepted from application of Section 1061.
In light of the complexity of the Section 1061 rules, the Proposed Regulations include reporting requirements on partnerships that have issued APIs. Because “owner taxpayers” must comply with Section 1061 on their individual returns, private investment funds will be required to track more-than-three year gains, three-year-or-less gains, capital interest gains and losses, and other items. The failure to properly report these items will result in penalties.
Please contact one of the authors of this legal update if you would like to discuss any of the contents or better understand if these rules are relevant to you.