Proposed Regulations Issued on Treatment of Carried Interests
August 12, 2020
By Richard Shapiro
After some delay, the IRS has issued proposed regulations under IRC Sec. 1061 (“Partnership Interests Held in Connection with Performance of Services”), added to the Internal Revenue Code (“IRC” or “Code”) by the 2017 Tax Cuts and Jobs Act (“TCJA”). IRC Sec. 1061 recharacterizes certain net long-term capital gains of a partner that holds one or more applicable partnership interests (“APIs,” generally referred to as carried interests) as short-term capital gains by applying a three-year holding period instead of a one-year holding period. These very jargon-laden proposed regulations –
- Provide taxpayers with definitional and computational guidance regarding the application of IRC Sec. 1061.
- Clarify the rules for certain exceptions to IRC Sec. 1061.
- Clarify which types of capital gains are included under IRC Sec. 1061 and which are not.
- Provide rules for calculating the recharacterized gain amount and provide for a lookthrough rule with respect to the sale of APIs.
Highlights of the proposed regulations follow.
Recharacterization Amount/Definition of API
IRC Sec. 1061(a) recharacterizes as short-term capital gain the difference between a taxpayer’s net long-term capital gain with respect to one or more APIs and the taxpayer’s net long-term capital gain with respect to these APIs if such long-term capital gain is calculated utilizing a three-year holding period rather than a one-year holding period. This difference is referred to in the proposed regulations as the Recharacterization Amount.
An API is an interest in a partnership’s profits which, directly or indirectly, is transferred to or held by a taxpayer in connection with the performance of “substantial” services by the taxpayer, or any other related person, in any applicable trade or business (“ATB”). For this purpose, an interest in a partnership includes any financial instrument or contract, the value of which is determined, in whole or in part, by reference to the partnership (including the amount of partnership distributions, the value of partnership assets, or the results of partnership operations -- this would preclude a taxpayer from entering into a swap with regard to the economics of its carried interest in order to get around IRC Sec. 1061). IRC Sec. 1061 applies to all partnership interests that meet the definition of an API, regardless of whether the receipt of an interest satisfies the “profits or carried interest” safe harbor (Rev. Proc. 93-27 and Rev. Proc. 2001-43) under which the IRS does not treat the receipt of a profits interest as a taxable event. Further, under the proposed regulations, if a taxpayer provides any services in an ATB and an allocation of partnership profits is transferred to or held by the taxpayer in connection with those services, those services are presumed to be substantial for this purpose.
While an API can be held directly by an owner taxpayer (“Owner Taxpayer”) – the person who is subject to federal income tax on the Recharacterization Amount, it may also be held indirectly through one or more passthrough entities (“Passthrough Entities”). The proposed regulations provide a framework for determining the Recharacterization Amount when an API is held through one or more tiers of Pass-through Entities. Each Passthrough Entity in a tiered structure is treated as holding an API (“API Holder”). An API Holder may be an individual, partnership, trust, estate, S corporation or a passive foreign investment company (“PFIC”) with respect to which the shareholder has a qualified electing fund (“QEF”) election in effect. (The clarification with regard to an S corporation, while expected, may still be challenged by some as being contrary to the statute.)
The proposed regulations provide that the determination of a taxpayer’s net long-term capital gain with respect to the taxpayer’s APIs held during the taxable year includes the taxpayer’s combined net distributive share of long-term capital gain or loss from all APIs held during the taxable year and the Owner Taxpayer’s long-term capital gain and loss from the actual or deemed disposition of any APIs during the taxable year (“API Gains and Losses”). Long-term capital gain or loss on the disposition of a capital asset distributed from a partnership with respect to an API is also treated as API Gain or Loss if the asset is held for more than one year but not more than three years at the time the distributee-partner disposes of the property. The holding period of the asset in the partner’s hands includes the partnership’s holding period with respect to the asset.
Importantly, the proposed regulations clarify that API Gains and Losses do not include –
- Long-term capital gain determined under IRC Sec. 1231 and IRC Sec. 1256;
- Qualified dividends;
- Any other capital gain that is characterized as long-term or short-term without regard to the holding period rules of IRC Sec. 1222 (e.g., capital gain characterized under the identified mixed straddle rules);
- Any amounts that otherwise are treated as ordinary income under any Code section, including IRC Sec. 751 and IRC Sec. 1245;
- Capital Interest Gains and Losses (i.e., long-term capital gains and losses with respect to an API Holder’s capital investment in a Passthrough Entity); and/or
- API Holder Transition Amounts (i.e., allocations to an API Holder of long-term capital gain and loss recognized on the disposition of assets held by the partnership for more than three years as of January 1, 2018, if the partnership has elected to treat these amounts as partnership transition amounts).
API Holder Transition Amounts are treated as long-term capital gains and losses and are not subject to recharacterization. The partnership must make a signed and dated election statement by the due date, including extensions, of Form 1065 for the first partnership taxable in which it treats amounts as partnership transition amounts.
Once a partnership interest is an API, it remains an API and never loses that character unless one of the exceptions to the definition of an API applies, regardless of whether the taxpayer or a related person continues to provide services in an ATB (defined below). This means that even after a partner retires and provides no further services, if the retired partner continues to hold the partnership interest, it remains an API. Similarly, if the partner provides services, but the required level of activity is not met in a later year, the partnership continues to be an API. Further, an API remains an API if it is contributed to another Passthrough Entity or a trust or is held by an estate. There is an important exception however, discussed below, for a third party who buys an API and does not provide services. Finally, if a new partner makes a contribution into a partnership that holds an API, that API will be an API to that partner even if that new partner is unrelated and does not provide services.
Unrealized API Gains and Losses
Unrealized API Gains and Losses include unrealized short-term and long-term capital gains and losses that would be allocated to the API Holder with respect to its API if the partnership sold all its assets at fair market value and the proceeds were distributed in a complete liquidation of the partnership on the relevant date. For example, Unrealized API Gains and Losses include all capital gains and losses that would be allocated to the API pursuant to a capital account revaluation. Unrealized API Gains and Losses that are recognized with respect to an asset or API held for more than one year on the date of its disposition become API Gains and Losses at the time they are recognized and do not lose their character as they are allocated through Passthrough Entities in a tiered structure. Many in the private equity industry have started utilizing waiver agreements similar to “management fee waivers” within which they will waive carry on an early portfolio company exit giving rise to less-than-three-year capital gains for a larger portion of a later gain that would have the three-year holding period. The preamble to the proposed regulations note that carry waivers, carried interest waivers and similar arrangements may not be respected and may be challenged under a number of bases, including substance-over-form or economic-substance doctrines. However, such waivers that result in the waived amount being subject to “significant entrepreneurial risk” should be respected as set forth in the proposed regulations under IRC Sec. 707(a)(2)(A).
Entities that are disregarded from their owners under any provision of the Code or regulations (e.g., grantor trusts and qualified subchapter S subsidiaries) are disregarded. Thus, if an API is held by or transferred to a disregarded entity, the API is treated as held by or transferred to the disregarded entity’s owner.
Definition of an ATB
For an interest in a partnership to be an API, the interest must be held or transferred in connection with the performance of services in an ATB. An ATB is defined as any activity conducted on a regular, continuous, and substantial basis which consists, in whole or in part, of raising or returning capital and either (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition) or (ii) developing “specified assets.” The proposed regulations provide that an activity is conducted on a regular, continuous, and substantial basis if the total level of activities meets the level of activity required to establish a trade or business under IRC Sec. 162 (“Trade or Business Expenses”). This requirement does not seem to be calculated by looking merely at the activities of the general partner as a separate entity, but rather would also include the work of management, as the management company is a related company and performs the work on behalf of the general partner. Specified assets are securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to the foregoing, as well as an option or derivative contract on a partnership interest to the extent that the partnership interest represents an interest in other specified assets. Developing specific assets takes place, for example, if it is represented to investors, lenders, regulators, or others that the value, price, or yield of a portfolio business may be enhanced in connection with choices or actions of a service provider or of others acting in concert with or at the direction of a service provider. However, a mutual fund that merely votes proxies received with respect to shares of stock it holds is not engaged in development.
Interests in a partnership may be issued to a service provider in anticipation of the service provider providing services to an ATB, but because an ATB does not exist at the time of the transfer, the interest is not an API. Once the service provider is providing services in an ATB, the interest becomes an API; at that point, its status as an API does not depend on whether the ATB continues to meet the ATB activity test.
Exceptions to API
API does not include the following:
- Any interest in a partnership directly or indirectly held by a corporation. For this purpose, an S corporation is not treated as a corporation. A PFIC, which is a corporation, with which a taxpayer has in place a QEF election is also not included in this exception.
- Certain capital interests, e.g., long-term capital gains and losses that represent a return on an API Holder’s invested capital in a Passthrough Entity (“Capital Interest Gains and Losses”). Where an owner disposes of an interest that is composed of a capital interest and an API, the proposed regulations provide a mechanism to determine the portion that is treated as Capital Interest Gains and Losses. This exception has clarified that an Owner Taxpayer can hold a Capital Interest and an API through the same partnership.
- Certain partnership interests held by employees of entities that are not engaged in an ATB.
- An API that is acquired by a bona fide purchaser who (i) does not provide services, (ii) is unrelated to any service provider and (iii) acquired the interest for fair market value.
The Code provides to the extent provided by the Secretary, IRC Sec. 1061(a) will not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors. A third-party investor is defined as a person who holds an interest in the partnership which does not constitute property held in connection with an applicable ATB and who does not provide substantial services for such partnership or for any applicable trade or business. There is uncertainty as to how this exclusion might apply to family offices, as the proposed regulations reserve with respect to the application of this exception.
Distributed API Property
As noted in the preamble, the distribution of property with respect to an API does not accelerate the recognition of gain under IRC Sec. 1061 or the proposed regulations. However, if Distributed API Property is disposed of by the distributee-partner when the holding period is three years or less (inclusive of the partnership’s holding period), gain or loss with respect to the disposition is API Gain or Loss. Distributed API Property retains its character as it is passed from one tier to the next. However, at the time that Distributed API Property is held for more than three years, it loses its character and is no longer Distributed API Property. If Distributed API Property is distributed from one Passthrough Entity to another and the upper-tier entity disposes of the property, the long-term capital gain or loss is included in the upper-tier entity’s long-term capital gain or loss as API Gain or Loss. If the property is distributed to an Owner Taxpayer and the Owner Taxpayer disposes of the property, the capital gain or loss is included in the Owner Taxpayer’s API one year disposition gain or loss. According to the preamble, this rule is necessary to prevent the avoidance of IRC Sec. 1061 because, absent such a rule, IRC Sec. 1061 could be avoided by the partnership’s distribution of an asset to the API Holder prior to the sale of the asset in situations in which the asset has been held by the partnership for three years or less.
Look-Through Rule on Sale of APIs
The proposed regulations include a limited look-through rule that is applied to the sale of an API that has been held for more than three years at the time of the disposition. The look-through rule only applies if 80% or more of the value of the assets held by the partnership at the time of the API disposition are assets held for three years or less that would produce capital gain or loss subject to IRC Sec. 1061 if disposed of by the partnership. If the look-through rule applies, a percentage of the gain or loss on the disposition of the API that is included in the one year disposition amount is not included in the three year disposition amount. This means that if a general partner member sells his general partner interest after holding it for greater than three years and the API owned by the general partner entity is comprised of a fund that generally does not hold assets for greater than three years, the capital gain on the sale of such partnership interest will be reclassified to short-term capital gain.
Holding Period Used For Applying IRC Sec. 1061
The proposed regulations provide that if a partnership disposes of an asset, it is the partnership’s holding period in the asset that controls. This includes the disposition of an API by the partnership.
Transfers of API to a Related Party
If a taxpayer transfers an API to a “related party,” then without regard to whether the transfer is otherwise a taxable event, the taxpayer includes in gross income, as short-term capital gain, the excess of (i) the net built-in long-term capital gain in assets attributable to the transferred interest with a holding period of three years or less, over (ii) the amount of long-term capital gain recognized on the transfer that is treated as short-term capital gain under IRC Sec. 1061(a) on the transfer. The term transfer includes, but is not limited to, contributions, distributions, sales and exchanges, and gifts. For this purpose, a related person includes only members of the taxpayer’s family, the taxpayer’s colleagues (i.e., those who provided services in the ATB during certain time periods) and a Passthrough Entity to the extent that a member of the taxpayer’s family or a colleague is an owner. A contribution to a partnership is not treated as a transfer to a related party.
The proposed regulations include an amendment to the IRC Sec. 704 regulations that currently provide that for purposes of making reverse IRC Sec. 704(c) allocations, a securities partnership may aggregate gains and losses from financial assets using any reasonable approach that is consistent with the purposes of IRC Sec. 704(c). Under the proposed regulations, an approach will not be considered reasonable if it fails to take into account the application of IRC Sec. 1061. Further, if the partnership aggregates gains and losses with respect to capital assets held for more than one year, for partial netting or full netting to be considered reasonable, the partnership must establish separate accounts (i) for taking into account each API Holder’s share of book API Gains and Losses and book Capital Interest Gains and Losses and (ii) for determining each API Holder’s share of tax API Gains and Losses and tax Capital Interest Gains and Losses. (How this will work practically remains uncertain.)
The proposed regulations include rules for providing information required to compute the Recharacterization Amount when there is a tiered structure.
The proposed regulations generally provide that the final regulations apply to taxable years of Owner Taxpayers and Passthrough Entities beginning on or after the date final regulations are published in the Federal Register. However, except for the proposed rules on transition amounts, Owner Taxpayers and Passthrough Entities may rely on the proposed regulations for taxable years beginning before the final regulations are published, provided they follow the proposed regulations in their entirety and in a consistent manner.
- Taxpayers may rely on proposed regulations regarding transition amounts for taxable years beginning in 2020 and subsequent taxable years beginning before the date final regulations are published without consistently following these proposed regulations.
- That the term “corporation” does not include an S corporation is proposed to apply to taxable years beginning after December 31, 2017. Similarly, that the term corporation does not include a PFIC with respect to which the shareholder has a QEF election in effect is proposed to apply to taxable years beginning after the publication of final regulations.