The Internal Revenue Service and the US Department of the Treasury pre-released final regulations, T.D. 9945, under Section 1061 on January 7, providing guidance to the holders of certain carried interests. These rules are of particular interest to sponsors of private investment funds.
A carried interest (also referred to as a profits interest, a promote, or a performance allocation) is a partnership interest that is received for services to (or for the benefit of) a partnership that entitles the holder to share in future profits but not in existing capital value. As a general rule, carried interest recipients do not recognize any compensation income upon the grant of a carried interest and instead are entitled to receive a distributive share of future profits (which could consist of capital gains) if the partnership is successful. As part of the 2017 Tax Cuts and Jobs Act, Congress added new Section 1061 to limit some of the perceived tax benefits associated with carried interests received by private fund managers.
Section 1061 provided that a taxpayer (other than a corporation) receiving a carried interest that was an applicable partnership interest (API) would be required to use a three-year holding period instead of a one-year holding period for determining long-term capital gains with respect to the carried interest. Section 1061 indicates that an API is a carried interest received or held by a taxpayer in connection with the performance of substantial services in any applicable trade or business (ATB). An ATB is a trade or business involving (1) raising or returning capital and (2) either (i) investing in or disposing of “specified assets” or (ii) developing “specified assets.” Specified assets consist of securities, commodities, real estate held for rental or investment, cash or cash equivalents, or options, as well as derivatives related to any of these items or partnership interests to the extent of the partnership’s interest in any of these items.
Proposed regulations under Section 1061 were released in August 2020. Our prior discussion of the proposed regulations can be found in our previous LawFlash.
The final regulations have modified the proposed regulations in four significant ways. First, the final regulations have clarified the application of a statutory exception for capital interests. Second, the final regulations have expanded the ability to fund a capital interest with debt proceeds. Third, the final regulations have significantly limited the recharacterization rule (Lookthrough Rule) that could apply to a sale of an API with a greater than three-year holding period where the underlying partnership directly or indirectly holds capital assets with a holding period that was less than three years. Fourth, the final regulations abandon the acceleration of gain concept that the proposed regulations had included for transfers of an API to a related party.
Section 1061(c)(4) provides that an API does not include a capital interest in the partnership that provides the taxpayer with a right to share in partnership capital commensurate with (1) the amount of capital contributed or (2) the value of the interest subject to tax under Section 83 upon the receipt or vesting of such interest. This statutory exception allows for the possibility that the holder of an API could also make a capital contribution that could give rise to allocations that were exempt from Section 1061.
The basic concept of the capital interest exception is that if the holder of an API also invests in the partnership in the same manner as other investors, then the economics associated with that capital interest should not be subject to Section 1061. The statutory language focuses on the actual amount contributed, but the proposed regulations incorporated a more complicated test that looked to respective capital account balances. Under the proposed regulations, an allocation qualified for the capital interest exception only if it was made in the same manner to all partners. The proposed regulations further indicated that an allocation would generally be deemed to satisfy the “same manner” requirement if it were based on the relative capital accounts of the partners and certain key terms (e.g., priority, type and level of risk, rate of return, and rights to cash or property distributions during the partnership’s operations and on liquidation) were the same.
Comments on the proposed regulations indicated that the original capital interest exception rule was overly burdensome and ignored many commercial realities (e.g., many partnerships do not maintain capital accounts). In response to the comments, the final regulations return to the focus of the statutory language and ask if the API holder that also contributed capital to the partnership is receiving distributions and allocations that are commensurate with capital contributed by unrelated third parties. The final regulations also abandon the prior “same manner” approach and specify that “commensurate” means that the allocations to an API holder with respect to its capital interest must be determined and calculated in a “similar manner” to the allocations calculated for unrelated third parties. Under the final regulations, the similar manner test can be applied on an investment-by-investment basis or on the basis of allocations made to a particular class of interests.
Under the proposed regulations, the focus on capital accounts created uncertainty about whether unrecognized gain, or “book-up” amounts, could be considered for purposes of the capital interest exception. The final regulations seem to close this possibility and indicate that a holder of an API may treat allocations of gain that he, she, or it has recognized for tax purposes, but not received as a distribution, as a capital contribution.
The final regulations also clarify that many common commercial arrangements will not preclude an allocation based on a capital contribution from qualifying for the capital interest exception. For example, the API holder’s capital interest may be entitled to tax distributions while an unrelated partner’s capital interest may not be. The final regulations also indicate that the fact that the API holder’s capital interest is reduced by the costs of services (whether a management fee or the carried interest itself) will not prevent a capital interest from qualifying for the capital interest exception.
Under the statute, the capital interest exception is based on capital contributions (or amounts recognized as income under Section 83 in a compensatory grant of a capital interest). While the proposed regulations shifted the focus to capital account balance (as opposed to capital contributions), the proposed regulations also provided that for these purposes, a capital account did not include the contribution of amounts directly or indirectly attributable to any loan made or guaranteed (directly or indirectly) by any other partner, the partnership, or a related person.
Comments on the proposed regulations indicated such loans were a common commercial arrangement and were a normal way for API holders to also have capital interests. However, the Internal Revenue Service (IRS) and the Treasury Department are still concerned that related party loans could be used to abuse the capital interest exception by allowing API holders to have capital interests that did not represent an actual economic outlay by the API Holder.
Accordingly, the final regulations adopt a compromise approach where proceeds from a related party loan can be contributed to create a qualifying capital interest if the API holder is personally liable for the repayment of the debt. An individual service provider will be considered to be personally liable for repayment of the debt if (1) the loan is fully recourse to the individual service provider; (2) the individual service provider has no right to reimbursement from any other person; and (3) the loan or advance is not guaranteed by any other person.
Section 1061 generally applies to substitute a three-year holding period for long-term capital gains for the normal one-year period with regard to an API. Because a partnership interest is a capital asset that is distinct from the underlying partnership assets, there is the possibility that an API itself could have a three-year-plus holding period, while the underlying partnership assets could have significantly shorter holding periods. This distinction could lead to the possibility of a holder of an API receiving a better result on the sale of the API than on the sale of the underlying assets. The proposed regulations addressed this issue by adopting the Lookthrough Rule, which was triggered when substantially all of a partnership’s assets would be subject to Section 1061 on an asset sale.
The IRS and the Treasury Department agreed with comments that the proposed Lookthrough Rule could be difficult to apply (particularly in the context of tiered structures). The Final Regulations modified the Lookthrough Rule so that it applies in two situations. The first situation is where an API would have a holding period of three years or less if the holding period did not include any period before an unrelated party was obligated to contribute substantial money or property (directly or indirectly) to a passthrough entity to which the API relates. For example, assume a partnership was formed in 2021 with modest contributions and an API was issued to a service provider, but the bulk of the capital investment from third parties did not occur until 2024. If the holder of the API attempted to sell the API in 2025, the API would technically have a four-year holding period, but the Lookthrough Rule would disregard the three years before the large 2024 capital investment. This means that gain on the 2025 sale of the API would be subject to Section 1061 because the API would be deemed to have a one-year holding period. The second situation where the Lookthrough Rule applies is where a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under Section 1061(a).
Section 1061(d) provides a special rule for the transfer of an API to a related person. The proposed regulations interpreted this rule as effectively accelerating gain in the event of a transfer to a related party in a transaction that would otherwise qualify for nonrecognition. For example, if the holder of an API made a gift of the API to a family member at a time when an actual sale of the underlying partnership assets would have produced gain subject to recharacterization under Section 1061, the proposed regulations would have required the holder to actually recognize that gain (as short-term capital gain) on the gift of the API. Comments on the proposed regulations criticized this interpretation and suggested that Section 1061(d) should be viewed as more of a recharacterization rule that would apply to the extent gain was recognized.
The IRS and the Treasury Department maintain that the statutory language of Section 1061(d) could support an acceleration concept, but concede that interpreting the provision as requiring an acceleration of gain would lead to gain recognition in nonabusive situations. Both the proposed and the final regulations incorporate a “once an API, always an API” concept except where there is a purchase of an API by an unrelated third party in a taxable transaction. So, if the holder of an API were to gift the API to a family member, there is little possibility for abuse because the family member would still have to account for the application of Section 1061 on any subsequent recognition of capital gains. Because of the limited opportunity for abuse, the final regulations have abandoned the acceleration concept for related party transfers and instead adopt a recharacterization approach.
Under the recharacterization regime, any long-term capital gain recognized on a transfer of an API to a related person may be recharacterized as short-term capital gain if a sale of the underlying assets would have produced gain that would have been recharacterized under Section 1061. This approach effectively incorporates a true lookthrough approach on the sale of an API to a related party. So, even if the sale would not be subject to the Lookthrough Rule itself, in a related party sale, the seller of the API will still need to account for the application of Section 1061 to the underlying assets.
While the following points may not have been newly added in the final regulations, it is helpful to keep them in mind when considering Section 1061 issues.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Richard S. Zarin