Reed Smith Client Alerts

On July 31, 2020, the Internal Revenue Service (“IRS”) and the Department of Treasury issued proposed regulations (the “Proposed Regulations”) on the taxation of carried interests under Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”).1 The Proposed Regulations address various unresolved issues regarding the application of Section 1061, and include detailed computational rules and reporting requirements. The Proposed Regulations generally apply to taxable years beginning on or after the date final regulations are published in the Federal Register, although taxpayers generally may rely on the Proposed Regulations for taxable years beginning before such date.

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”).