Executive Summary of Certain Aspects of the Proposed Regulations
- The applicable holding period for Section 1061 purposes is the holding period in the capital asset sold (subject to a limited “lookthrough rule”).
- Section 1061 generally cannot be avoided through distributions of partnership property to holders of carried interests (instead of the partnership selling such property) if the partnership’s holding period in such property is three years or less.
- Section 1061 generally does not apply to gains characterized as long-term capital gain without regard to the actual holding period (e.g., long-term capital gain under Section 1231, mark-to-market gains with respect to “Section 1256 contracts” and qualified dividend income).
- Taxpayers cannot avoid Section 1061 by holding carried interests through an S corporation or through a “passive foreign investment company” (“PFIC”) for which a “qualified electing fund” (“QEF”) election is made.
- The rules applicable to the Section 1061 exception for “capital interests” are mechanical, and many investment funds may find it difficult to satisfy the applicable requirements.
- The preamble to the Proposed Regulations warns taxpayers that attempts to circumvent Section 1061 through carry waivers may be scrutinized under existing authorities.
General Overview of Section 1061
Section 1061, enacted as part of the Tax Cuts and Jobs Act of 2017 (the “TCJA”), modifies the taxation of carried interests (e.g., special allocations to the general partner of an investment fund). In general, Section 1061 increases the required holding period to obtain long-term capital gain treatment (from one year to three years) for gain allocated to a service provider with respect to an “applicable partnership interest” (“API”). An API is any partnership interest that, directly or indirectly, is transferred to or held by a taxpayer in connection with the performance of substantial services by the taxpayer (or related person) in an “applicable trade or business” (“ATB”). An ATB generally is any activity conducted on a regular, continuous, and substantial basis that consists, in whole or in part, of (i) raising or returning capital, and (ii) either investing in or disposing of, or developing, “specified assets”. Specified assets are defined as securities, commodities, real estate held for rental or investment, cash or cash equivalents, and options or derivatives with respect to any of the foregoing, and partnership interests to the extent of the partnership’s proportionate interest in any such assets.
In general, an API does not include (i) any partnership interest held directly or indirectly by a corporation (the “Corporate Exception”) or (ii) any capital interest in a partnership that gives the taxpayer a right to share in partnership capital based on (1) the amount of capital contributed or (2) the value of such interest subject to tax under Section 83 upon receipt or vesting (the “Capital Interest Exception”).
The Proposed Regulations
Set forth below is a summary of certain provisions included in the Proposed Regulations.
Applicable Holding Period for Section 1061. Section 1061(a) requires the taxpayer to determine the holding period “with respect to” APIs, which led to uncertainty as to which holding period was relevant: the taxpayer’s holding period in the API or the partnership’s holding period in the asset sold. The Proposed Regulations clarify that, subject to the “lookthrough rule” (as described below), the applicable holding period for Section 1061 purposes is the holding period in the capital asset sold (i.e., the capital asset sold by the partnership in which the taxpayer holds an API or in the case of a sale of an API, the API itself). Accordingly, if the partnership sells a capital asset, the holding period for purposes of Section 1061 is determined at the partnership level (regardless of the taxpayer’s holding period for the API). On the other hand, if the taxpayer disposes of the API in a taxable transaction, the relevant holding period for Section 1061 purposes is the taxpayer’s holding period in the API.
For example, if a partner held an API for three years or less, but the partnership sold a capital asset, which the partnership held for more than three years, Section 1061 would not apply to recharacterize any portion of the taxpayer’s allocable share of such gain as short-term capital gain. Conversely, if a partner held an API for more than three years and the partnership sold a capital asset, which the partnership held for three years or less, Section 1061 would apply to recharacterize the holder’s allocable share of such gain as short-term capital gain, notwithstanding that the partner held the API for more than three years.
Lookthrough Rule. As noted above, if the partner disposes of an API in a taxable transaction, the relevant holding period for Section 1061 purposes is the partner’s holding period in the API, and not the partnership’s holding period in its assets. However, the Proposed Regulations include a limited “lookthrough rule” (the “Lookthrough Rule”) that may apply upon the disposition of an API with a holding period of more than three years.
- Substantial Amount of Underlying Assets with a Holding Period of Three Years or Less. In general, under the Lookthrough Rule, if 80 percent or more of the aggregate fair market value of the assets (determined without regard to cash and cash equivalents) of a partnership that granted an API has a holding period of three years or less, a portion of the taxpayer’s capital gain on the taxable disposition of such API will be recharacterized as short-term capital gain under Section 1061, notwithstanding that the taxpayer’s holding period in the API exceeds three years.
- Lower-Tier API has a Holding Period of Three Years or Less. Under the Lookthrough Rule, if a taxpayer holds an API through intermediate entities and any such intermediate entity has a holding period in the API of three years or less, all of the taxpayer’s capital gain on the taxable disposition of such API will be recharacterized as short-term capital gain under Section 1061.
Distributed Property. The Proposed Regulations generally provide that if a partnership distributes property with respect to an API, long-term capital gain or loss on the taxpayer’s disposition of such distributed property is subject to recharacterization under Section 1061 (i.e., the distributed property is treated as an API). The taxpayer’s holding period for the distributed property includes the partnership’s holding period for such property. For example, if a partner receives a distribution of stock or securities that were held by the partnership for one year, the distributed stock or securities are treated as an API subject to the recharacterization rules and, consequently, the distributee-partner would need to hold such stock or securities for more than two years to avoid the application of Section 1061.
Excluded Capital Gains. The Proposed Regulations provide guidance on certain types of income that are not subject to recharacterization under Section 1061 because the character of such income as long-term capital gain does not depend on the holding period under Section 1222. These items generally include long-term capital gain under Section 1231 and Section 1256, qualified dividend income, REIT and RIC capital gain dividends (to the extent attributable to capital assets held for more than three years or otherwise not subject to Section 1061), certain long-term capital gain inclusions from a PFIC for which a QEF election has been made (subject to certain reporting requirements) and other gains characterized as short-term or long-term without regard to Section 1222 (e.g., capital gains and losses identified as mixed straddles under Section 1092(b)).
Corporate Exception. One question raised by commentators was whether Section 1061 could be avoided pursuant to the Corporate Exception by holding an API through a corporation not subject to U.S. federal income tax. However, in Notice 2018-18 (issued on March 19, 2018), the IRS informed taxpayers that regulations under Section 1061 would provide that S corporations would not be treated as corporations for this purpose. The Proposed Regulations confirm such position. In addition, the Proposed Regulations exclude from the Corporate Exception APIs held by PFICs for which a QEF election has been made.
Capital Interest Exception. The Proposed Regulations include detailed requirements that must be met for an interest in a partnership to qualify for the Capital Interest Exception. These requirements include the following: (i) allocations must be made in the same manner to all partners during the partnership's operations and on liquidation, subject to carve outs for preferred returns made to unrelated non-service partners and cost differences (e.g., differences in management fees), (ii) the partnership must make allocations on the same terms to unrelated non-service partners having a significant aggregate capital account balance (defined as 5 percent or more of the aggregate capital account balance of the partnership at the time the allocations are made) and (iii) the partnership agreement and the partnership’s books and records must clearly segregate the capital interest allocations from allocations with respect to APIs. Due to the manner in which many investment funds are structured (e.g., funds that calculate returns to capital on a transaction-by-transaction basis and funds where sponsors do not incur a carried interest with respect to their sponsor commitment), it may be difficult to satisfy such requirements.
In addition, the preamble to the Proposed Regulations states that transactions giving rise to a deemed capital contribution (e.g., a recapitalization or conversion of a general partnership interest into a limited partnership interest), does not convert an API into a capital interest eligible for the Capital Interest Exception.
Gain on the disposition of a capital interest does not necessarily qualify for the Capital Interest Exception. Rather, a multi-step process must be performed to determine whether gain or losses allocable to the partner from the hypothetical liquidation of the partnership (and any lower-tier partnerships) would be eligible for the Capital Interest Exception. Any gain on the disposition of a capital interest that does not qualify for the Capital Interest Exception is treated as gain with respect to an API (and, therefore, subject to Section 1061).
Related Party Transfers. Under Section 1061(d) and the Proposed Regulations, short-term gain is recognized on certain transfers of an API that would otherwise not be subject to current taxation. More specifically, the Proposed Regulations provide that, if an API (or property distributed with respect to an API) is transferred (including by gift), directly or indirectly, to a related party (generally defined to include family members and certain persons who provided services during a specified period to the same ATB in which the taxpayer performed services), the taxpayer must recognize short-term capital gain equal to the excess (if any) of (i) the net long-term gain from partnership assets having a holding period of three years or less that would be recognized by the partnership on a hypothetical sale of all of its assets at fair market value over (ii) the amount otherwise treated as short-term capital gain under Section 1061 with respect to such transfer. The transferred interest retains its character as an API to the transferee. This rule does not apply to a tax-free contribution of an API to a partnership (under Section 721); rather, any related API gains must be allocated back to the contributing partner when recognized (under Section 704(c) principles).
Carried Interest Waiver. Following the enactment of the TCJA, fund sponsors have considered using “carry waivers” as a means to avoid the application of Section 1061. A "carry waiver" generally includes arrangements pursuant to which fund sponsors would waive distributions (and related allocations of income) with respect to their carried interest when Section 1061 would apply in exchange for the right to receive potential future distributions (and related allocation of income) that are not subject to Section 1061. The Proposed Regulations do not address the tax treatment of such arrangements under Section 1061. However, the preamble to the Proposed Regulations warns taxpayers that attempts to circumvent Section 1061 through carry waivers may be challenged under existing authorities, including substantiality, the partnership anti-abuse rules, the substance over form doctrine and the sham transaction doctrine. Accordingly, similar to management fee waivers, while such arrangements may be respected if drafted to include meaningful economic risk, the preamble to the Proposed Regulations notifies fund sponsors that such arrangements are subject to scrutiny.
Other Guidance. The Proposed Regulations provide further guidance on the application of Section 1061, including the following:
- Rules regarding the calculation of amounts recharacterized as short-term capital gain under Section 1061.
- Guidance regarding the definitions of API and ATB (including presumptions regarding whether services provided by an individual are “substantial”).
- Clarification regarding the application of Section 1061 to tiered partnerships.
- Transition rules for pre-2018 gains (including a partnership election to exclude all pre-2018 long-term capital gains and losses, subject to certain limitations, from the determination of the amounts recharacterized as short-term capital gain).
- Reporting requirements of partnerships, REITs and RICs to enable taxpayers to make the determinations and calculations required under Section 1061 and the Proposed Regulations.
Effective Date. The Proposed Regulations generally apply to taxable years beginning on or after the date final regulations are published in the Federal Register. However, the rule excluding S corporations from the Corporate Exception applies to taxable years beginning after December 31, 2017, and the rule excluding PFICs for which QEF elections have been made from the Corporate Exception applies to taxable years beginning after August 14, 2020 (i.e., the date of publication of the Proposed Regulations in the Federal Register). Taxpayers may rely on the Proposed Regulations for taxable years beginning before the date final regulations are published in the Federal Register, provided taxpayers follow the Proposed Regulations in their entirety and in a consistent manner.
- All Section references herein are to the Code.
Client Alert 2020-492
