On-Demand: Section 1061 Taxation of Carried Interest Final Regulations
- Feb 24, 2021
Our panelists provided an overview of the recently released final Treasury Regulations under Section 1061.
Irina Kimelfeld:Good afternoon. And thank you for joining us today. As we will be going through the IRC 1061 Carried Interest Legislation, the final regulations have come out in January. So, we think this is a good time to do an overview of what the carried interest rules are and highlight the differences between the final regulations as they've been published and the proposed regulations that came out in the summer of 2020.
Irina Kimelfeld: So, just to give a little bit of an overview how we got here. Historically, there has been a reliance on Revenue Procedures 93-27 and 2001-43 for the grant of profits interest in partnerships, otherwise, commonly known as carried interest. Traditionally has not been taxed, assuming it met the requirements of the revenue procedures. And as the results of these profits interests, the carry recipients, to the extent the underlying assets, were held for greater than one year, received capital gain allocated to them from the sale of assets.
And they've been several attempts over the last decades that really became in earnest in 2007 to reclassify these capital gains that were allocated to general partners and other service providers as ordinary income, specifically, in theory, addressing that these are services being provided as opposed to putting capital to work. So, the concern has always been there.
Why do people who provide services, specifically to investment partnership asset managers, receive this capital gain treatment at preferred rates, as opposed to other service providers who receive ordinary income. So, the first attempt at addressing this really came out in 2007, and we will come back as we wrap up our hour today to what happened to that legislation as that coming back again.
But ultimately, it was really addressed in the Tax Cuts and Jobs Act Of 2017 by passage of Section 1061. Which really didn't treat the carried interest as ordinary income as the 2007 proposed rules try to do, but rather reclassifies certain long-term capital gains to short-term capital gains. So, achieving similar effect to ordinary treatment, but only on a limited set of gains. The proposed regulations came out in August of 2020 that have provided some clarity and application rules of Section 1061.
And the final regulations came out in January of 2021, giving us further guidance clearance and making certain changes to the proposed regulations. And it looks like we're not quite done yet with this area as there are new proposed legislation that is coming out, so this continues to be on the forefront of lawmakers' minds. So as an overview, we'll go back to, what does Section 1061 do?
As I said, it reclassifies capital gains received from applicable partnership interests, which is a defined term, where from disposition of these APIs, a short term if the holding period is less than three years. So, they limited it. It effectively redefined long-term capital gains for certain people, for certain holders of partnership interests from one year to three years. So, what is an API?
API is any interest in a partnership, which directly or indirectly is transferred to, was held by an owner taxpayer or passthrough taxpayer, all those terms are defined, in connection with performance of substantial services by the owner taxpayer or by the passthrough taxpayer or any related person, including services performed as an employee in any applicable trader business, unless there is an exception provided in the Regulations that applies.
And the interest in the partnership also includes any financial instruments or contracts, the value of which is determined by reference to the partnership value. So, once the partnership interest is an API, once it is considered to be an API, the partnership interest remains an API, unless and until the requirements of one of the exceptions are satisfied. And we'll go through those exceptions. So, schematically, this is what it looks like, right? You have a fund. And the interest and the fund is issued to the GP for provision of significant services.
And then, anything up the chain will once again the API until it gets to the ultimate taxpayer, defined as owner taxpayer, right? So, if you have an individual owner taxpayer going directly into the GP, where there is intermediate entities, everything up the chain is considered API. And the gains that are coming up from the fund up this chain will need to be potentially reclassified if they're generated from assets held for less than three years.
Irina Kimelfeld:Once an API, always an API. It's a good general rule of thumb. There are exceptions. There is a way to cleanse an API status, which we will talk about, but generally, by selling an API interest to an unrelated third party. But it is a difficult way to cleanse the API status. So, if we go back to the definition of what is an API, it's interest in partnership issued for provision of services in applicable trader business. So, applicable trader business is raising or returning capital actions.
And investing or developing actions are conducted by an owner taxpayer, passthrough taxpayer or one or more related persons. So, the raising and returning capital actions and investing and developing actions do not have to happen in the same tax year, right? So, if we think about a typical fund, right, you can have the management company, which would be related person raising funds, and then investing those funds over the several years following.
So, it doesn't have to happen at the same time, but it has to happen at some point of time together. The substantial services is not defined. But if the partnership interest is transferred in connection with these services, it is presumed that the services are substantial. So, if there is a partnership vendor is being issued to a service provider, the fact that they're receiving the partnership interest effectively means that the services are substantial.
So, then we're going to what does investing, developing actions mean? So, it's actions involving either investing and, or disposing of specified assets or developing specified assets. And the specified assets are securities that are defined in Code Section 475(c)(2), which generally covers equity, debt instruments, derivatives, et cetera, which is really anything that you can think of as securities would fall into the definition.
Commodities as defined under Section 475(e)(2), real estate held for rental or investment, and cash and cash equivalents. Interestingly, an interest in a partnership to the extended the partnership hold specified assets is itself a specified asset. However, a partnership that is an operating type partnership would not fall under the definition. So, that is an open question, what happens to the funds that are exclusively investing in operating partnerships?
Probably not the most common scenario, but possible. And developing specified assets is basically representing anybody who's represented to investors, lenders, regulators, or other interested parties, that the value price or yield of the portfolio business may be enhanced or increased in connection with choices or actions of a service provider. So, you're either investing or developing specified assets, then that business and your receiving partnership interest in connection with providing those services, that partnership interest becomes API.
But there are exceptions. So, what is not an API. And the final regulations provide four broad categories of what is not an API. So, partnership interest held by a corporation, it is in the Code Section, not just in the Regs, that partnership interests that are held by corporations are not considered to be API. However, after the legislation was issued, the IRS has come out and said that this exception does not apply to S Corporations or PFICS that have made QEF elections.
The IRS has come out and said that in a ruling. Then IRS has come out and said that in the proposed regulations, and it has come out and said that in the final regulations again. Some do continue to argue that Treasury did not have broad regulatory authority to exclude, right, the plain reading of the statute does say that the partnership interest held by a corporation is not API.
So, some have argued that the Treasury just did not have the authority to redefine corporation effectively by saying that it does not include S Corporations and PFICS that have made a certain election. It is a view and the view that may need to be litigated in the future. At this time, the Regulations say what they say. So, we are living with the rule. The other exception that we will spend quite a bit of time talking about is the capital interest gains and losses are not included in the definition of API.
So, if we have partners who are making capital contributions to the funds and receiving allocations commensurate with their capital contribution, their capital interest in the fund, gains from that interest, from that investment in the fund would not be reclassified as they would not be considered API. And a lot of space in the Regulations is spent talking about what does that mean, and how do we separate capital interest from API interest to the extent them both exist?
Partnership interest held by an employee of another entity not conducting ATB. That is if you have interest issued in a partnership to an employee of another entity, and the employee is not providing services to the issuing partnership, then that's not API. Portfolio investment on behalf of the third-party investors, that exception is in legislation. There are no regulations that have been issued to date on that point. It continues to be reserved. This is really called family office exceptions.
So, it's basically stay tuned, reserved section. And the last exception is the partnership interest acquired by purchase by an unrelated person. So, this is the situation where I said it potentially a way to cleanse. And API is when it is sold to somebody who's not related to the seller and to the funds and to the entire complex. And is not providing services after the purchase of the API. So once the API is sold, any gain or loss is recognized by the seller as API. But going forward, that interest is no longer considered to be API.
Irina Kimelfeld:It is true. So, 78% of people have gotten it right. We do have some questions, which I'm probably not going to go in water and will not get to all of them right the second. We will address as many as we can before the end of the session or we'll reach back out to you if we don't get to them. I think there are some questions around the effective date of the final regulations and what effect they have on 2020.
Tax returns, we will be getting to that and under the effective date. So, stay tuned for that. And then, we will go through the Q&A section and try to get through as many of those as we can. I'm going to turn it over to Bill to talk about the capital interest exception.
Bill Yahara:Hello, everyone, good afternoon. As Irina had been discussing, there were some changes to the proposed regulations that were introduced by the final regulations. The majority of those changes, there were four major changes, in which one was the capital interest exception. There's one regards related parties. There's another one that considers the look-through role. And there's also what to do with loans.
The first one we're going to handle here today deals with the capital interest exception. And this is, by and large, one of the biggest that has come out of the final regulations. It provided a lot of clarity. And what it did is it allowed an allocation to be based in a similar manner, as opposed to the same manner. And this interest exception, it excludes capital interest gains and losses from recharacterization, including capital interest allocations and capital interest disposition amounts.
And allocation would be considered a capital interest allocation if the allocation to the API holder with respect to its capital interests determined and calculated in a similar manner as the allocations with respect to capital interests held by similarly situated unrelated non-service partners who have made significant aggregate capital contributions. So, what that means essentially is from the propose to the final, they kept a lot of the determinant factors to see if an allocation would be commensurate with capital.
However, if you remember back in the proposed regulations, they were looking to the maintenance of capital accounts, which is covered under 704(b). And they were looking for that to see if an allocation would be accepted. And in there, they included terms such as, is the priority the same as the unrelated non-service partner requirement? And is the type or level of risk associated with that capital contributed? How does that look?
Are the rights to property distributions during operations of it or distribution on liquidation, how does that look compared to the unrelated non-service partner requirement? So, what this did is the final regulations got rid of the 704(b) allocation because a lot of hedge fund managers, private equity managers, venture capital type entities were having a hard time trying to fit their allocation mechanisms into the language of the proposed regulations. So, they made that change for us.
And they made the allocation now acceptable, if it's commensurate with capital contributor. Which is essentially, in order for a capital interest to occur, it has to be commensurate with capital. And that's defined really on the unrelated non-service partner requirement. And the unrelated non-service partner requirement, it's where a partner must have a significant aggregate capital contribution in relation to the capital contributions all the partners.
And in this case, significant is at least 5% of the aggregate capital contributed at the time the allocations are made. And in the case of different classes of investment or deal by deal allocations, the unrelated non-service requirement must be made at the class or may be made at the class or the investment level. Another thing to really think about here is the Treasury came out and said that they don't want you to incubate a fund or start a fund and try to get long term without having an unrelated non-service partner, the requirement met.
So, it's going to look at the time of contribution and make sure that there's a 5% of the aggregate capital contributed in order to be commensurate with capital. And another thing that the final regulations brought up was contributed capital and related allocations must be clearly identified in the LPA and books and records. So, it's probably prudent for a lot of hedge funds, private equity, venture type funds to really ask counsel if their capital will meet these requirements.
Because if it doesn't meet the requirements, it's clear that it could essentially be kicked out and be an API. And that's a harsh consequence. So, the second major change was the capital interest exception dealt with capital interest acquired with loan proceeds. And the proposed regulations came out and said that a capital account for a prospective partner that is funded by a loan or advance made or guaranteed by a partnership, partner or related person would not be included in the contributing partners' capital account for capital interest allocation purposes.
Only the repayments on such loan would be included in the contributing partner's capital account. Well, the final regulations change that. And now, within the final regulations, if a partner has recourse liability to the individual service provider on to all the following conditions, then it will be respected as a capital interest exception. And some of these are the loan or advance is fully recourse to the individual service provider. The individual service provider has no right to reimbursement from any other person.
And a loan or advance is not guaranteed by any other person. Guarantees still propose a significant problem for the IRS and Treasury. This is still under examination, and it may be further guidance provided in this area. So, reinvested API gain, this is one of my favorite because back in the proposed regulations, there were still a lot of open questions on whether or not a reinvested API gain could be reinvested and the earnings on that be not subject to the API and would be a good capital interest.
So, final regulations cleared that by including that if an API holder's allocated API gain and passthrough entity to the extent that an amount equal to the API gain is reinvested in the passthrough entity by the API holder, either as a result of an actual distribution and read contribution of an API gain amount or the retention the API gain amount by the passthrough entity, the amount will be treated as a contribution to the past or entity for capital interest that may produce capital interest allocations for the API.
This essentially means is that if you have a realized piece, you don't have to pull it out of your phone and then reinvest it. In order to have an API gain, something needs to be realized. And unfortunately, unrealized gains are not going to work, which a lot of practitioners were hoping was going to work by a clear reading of the proposed regulations. But the final regulations came out and blocked that. So, the example provided in the Regs make it clear that only reinvestment realized gains provide the capital interest.
And there's a provided example discussed, in which it's a private equity type scenario. And the hedge fund API holders could consider receiving distribution of crystallized unrealized carry and recontributing it after period of time to establish a capital interest. So, what this is saying is, what's the planning mechanisms around unrealized carry? Right? Can I crystallize that, pull it out of the fund, recontribute it?
What's the exact amount of timing do you need to have in order to cleanse that unrealized carry? Is there a time? Is it done? Because there was no tax, actually, on that 1061 piece that was recorded by anyone. Also, the unrealized carry, does it make sense? Or is there a planning opportunity to pull it out of the fund that you're in, contribute to another fund, and then put it back into the fund? That's all getting kicked around right now. And it's still questionable, rather, if that would create a capital interest.
So, it's important to develop tracking mechanisms for realized and unrealized carry that has been left invested in fund to accurately track capital interest allocations. If you have a partial netting or full netting entity, the final regulations tell you that any reasonable approach to track these pieces will be acceptable. And what's a reasonable approach? I'm sure plenty of those have some great ideas.
But if it's not accepted, Treasury always has 1061(f) to fall back on and say that it's not a capital interest because of A, B, C. But there's still a few things going on there and a few things that we need to look at to see if there's a way to cleanse that without it producing an API. So, here's an example, 1061-3 example three, reinvestment of realized API gain, I mean, it makes it pretty clear. Reinvestment of realized API gain, A, B and C are partners in PRS, a partnership.
At the beginning of Year 1, A is issued in API in PRS in exchange for providing substantial services to PRS in an applicable trader business. A has no capital interest in PRS. During Year 1, PRS's assets appreciate by 100. At the end of Year 1, under the terms of its partnership agreement, if PRS were to sell all of its assets at their fair market value and distribute the proceeds in a complete liquidation, A would receive 20 with respect to its API.
Thus, at the end of Year 1, A has 20 of unrealized API gain. In Year 2, PRS sells Asset X, an asset that PRS owned in Year 1, and allocates $8 of the long-term capital gain to A as an API gain. As a result, eight of A's $20 of unrealized API gain becomes API gain that is subject to Section 1061. A reinvests the share of the proceeds from the Asset X sale in PRS. As a result, under paragraph (c)(3)(iii) of this section, A has an $8 capital interest in PRS.
So, you can see there, they realized the gain, right? They picked up the $8. They realized they paid taxes, right, under1061 on that piece. That's why it's cured and cleansed. The other piece, however, is unrealized. And it's not going to be cleansed until 1061 applies to that piece.
Irina Kimelfeld:So as Bill mentioned, the example is clearly very much private equity drive example. So, we are continuing to hope that there would be something more on point for hedge funds. This particular section, as we will talk about in the applicable dates, this portion of the final regulations will ultimately have the effective date for 2022 tax year. So, for 2020 and 2021 tax years, the proposed regulations are still in effect.
So, whatever positions were taken with respect to unrealized carry, specifically in hedge funds space, those potentially could still be in good positions. But starting with 2022, it's very clear that unless something changes between now and then, the unrealized carry does not give us good capital interest.
Bill Yahara:Irina, we have a question coming in, where most VC funds are 99/1 LP, GP, are you saying now, they have to be at least 95/5? And I would say from a clear reading the final regs, go ahead, Irina.
Irina Kimelfeld:So, no. So, the 5% unrelated third-party partner was just given as a benchmark, right? So, the capital interest needs to be allocated commensurate with a third-party unrelated partner. And for someone to be considered that, your benchmarking partner needs to be at least a 5% capital interest holder. So, if you're going to say that the allocations for capital interest are commensurate with unrelated partner allocations, you need to be benchmarking against someone who at least has a 5% holder.
It doesn't mean that the GP actually has to have 5% investment. It just means that the benchmarking partner that you're relying on to say that my allocations are commensurate with someone who is not a service provider and unrelated needs to be at least a 5% holder.
Bill Yahara:Excellent. We have a slide on that coming up. So, we'll get there. So, capital interest disposition amounts. It's important to know that the amount of long-term capital gain or loss recognized on the sale of disposition of all or a portion of a passthrough interest is deemed to be an API gain or loss, unless it is determined to be a capital interest disposition amount. So, how do you determine the capital interest disposition amount?
The capital interest disposition amount is equal to long-term gain or loss recognized times the ratio of the capital interest gain or loss resulting from a hypothetical sale of all the assets through tiers at fair market value that would be allocated to the seller over the total long-term gain or loss from the hypothetical sale that would be allocated to the seller.
So, the way to really look at this is, if you or a transfer and you're selling an API gain, and you recognize long term capital gain upon the disposition to the passthrough, and if all of your long-term gain and capital interest gain or loss is a loss, it is considered all API gain. So essentially, what this is doing is if you have a long-term gain on the transfer the applicable partnership interest, this is saying is if you had capital interest gain or loss, and if that was all the loss, then of course, all the API would have to be a gain.
The flip of that is if the long-term capital loss and capital interests gain or loss is a gain, all API is a loss. Essentially, if the transfer recognize a long-term capital loss on the disposition of the passthrough interest, essentially, and if they had capital interest gain or loss, if that was a gain, then of course, everything else would have to be in API loss.
Irina Kimelfeld: So, what this is really trying to do is in a case where you have a component of API, you have one interest and there's component of API, and there is a component that is capital interest and you sell your share of a partnership, how do we trace back to what is API? And what is capital interest gain, right? So, the idea is that if you sell partnership in which you have an API, the default is that the gain on that sale is API, right?
You can cleanse your API taint by just selling your partnership interest. But if you do have capital interest in that same partnership, then we're trying to trace back what portion of the gain you're realizing today is really attributable to your capital interest, and what portion is attributable to your API. And if everything is going the same way, right, you're recognizing the gain, and there's inherent gain in the partnership's assets, right?
So, if all the assets were liquidated for fair market value, there is a gain. So presumably, part of that gain would be allocated to the partner as a capital interest partner. So, we're trying to get to that ratio. How much of that gain is really attributable to the capital interest? How much of that gain is attributable to API? So, that's just a ratio there, right? But if it's going the other way, if inherent in the partnership, if the assets are depreciated.
So, if you were to sell all the assets down the chain of ownership, you end up with a loss but you're selling your partnership interest for a gain, well, then it's clear that all of the gain is API, because there's just not inherent gain in the capital interest. And the flip side of that is that if there's inherent gain in the partnership's assets, but you're recognizing the loss, the loss then has to, by default, be attributable to API.
But this is a tracking mechanism to ensure that you're still picking up API on the sale of the partnership with a recognition that some of it is attributable to capital interest.
Bill Yahara:Irina, we have another question that came in, exception for reinvested realized gains, does it need to be taxable in order to count as reinvested?
Irina Kimelfeld:So, the Regulations did not specifically come out and say that. The Regulations said what they said, right, that that unrealized does not give you capital interest. Presumably, that's another way of saying that if it's not taxed, it doesn't give you a capital interest. I hope I'm answering the question. If there is another scenario that you're thinking of, then-
Bill Yahara:I think that's perfect. Thank you.
Bill Yahara:Here's a sample of a passthrough interest. I have this here, but you can go through this on your own time and we have a lot of information to get through. If you have any questions, you can either reach out to Irina or I, we'll be happy to discuss this example with you. So, the next thing we want to get to and we have some questions on this, quite a few actually. So, the partnership interest acquired by purchase by an unrelated person. What does this mean? And who does it apply to? And where are we going with this, right?
It impacts hedge funds, it impacts private equity type firms as well and venture capital, you name it. So, if a person acquires an interest in the partnership by taxable purchase for fair market value that would otherwise be an API, the transferor of the interest will be treated as selling an API but the acquirer will not be treated as acquiring an API.
If immediately before the purchase, the acquire is not a related person with respect to any person who provides services in the relevant applicable trader business or any service provider who provide service to or for the benefit of the acquired partnership or a lower tier partnership. And at the time of the purchase the acquired has not provided, does not provide, and does not anticipate providing services in the future to or for the benefit of partnership being acquired, directly or indirectly, to any lower tier partnership.
So, the preamble to the proposed and final regulations specify that an exception only applies the purchase of an API, not to contributions of cash or property in a non-recognition transaction under Section 721(a). So essentially, what this is getting to is, you're in a better spot if you purchase an applicable partnership interest, as opposed to putting a contribution straight into a GP and the GP funding a fund and relaying that contributed capital into the fund. Most GPs, there's not an unrelated service provider there.
So, there could be an issue. Co-invest vehicles, right? There's an issue there that's still need further guidance from the Treasury and IRS, where the co-invest vehicle essentially always pull the money. And at times, there wasn't an unrelated service provider. So, what does that mean? The 5%, 95% is not being met there. Do you put it directly into the fund if there's any no harsh consequences? Or do we wait for further information and guidance to be sent our way?
Irina Kimelfeld:Right. We'll get to the polling questions just one second. The 721(a) is in both preambles or the reference to the 721(a) not being treated the same way as a sale to an unrelated third party to cleansing API's. status. It's in both in preambles, it is not in the language of the Regulations, however. But the IRS or Treasury has made it clear that contributions do not work. So, if there are situations where a GP is getting additional capital, it needs to be capitalized.
Care should be given as you could be having a situation where a person is stepping into an API without having really provided services. So, that's the concern. There probably a number of concerns that IRS was trying to address by specifying that contributions do not get the same treatment, do not cleanse the API status as an outright sale would. But that's definitely a planning consideration when considering additional capital coming into the GP.
Irina Kimelfeld:Questions here that have come in around interest in dividends, so not really gain but other ordinary type items that are taxed. So, can they create capital interest? So yeah, so reinvested, presumably, interest in dividends would in fact be realized. So, reinvested either by just leaving it in the fund or taking it out and recontributing to the fund. The amounts that have been taxed and left in the fund would give good capital interest.
Bill Yahara:So, the answer is 50, 49.6. It seems like we are in a tie there. According to the final regulations, unrealized carry, it's from what we're reading and what we see in the final regulations. It may not be reinvested API gain. But a lot of this is subject to interpretation, still. And further guidance will be needed in some of these areas.
Irina Kimelfeld:I'm not sure if these responses are what's in the rules, or more of an opinion poll of what people think should happen.
Bill Yahara:Or hope.
Irina Kimelfeld:Is it an opinion poll? Okay. So, recharacterized amount. So, we went through what is API and the situations where you do not have API. And then, we get to the rules and the regulations that actually address what happens. Once we have an API, what does that mean?
So, what that means is that the gain or loss that is allocated to the API holder or gain or loss from sale of the partnership interest that is API is going to get reclassified from long term to short term to the extent that the assets or the partnership interest has not been held for more than three years. And the mechanism for doing that, right, it's easy to say, well, you now reclassify from long term to short term.
Well, the mechanism of calculating what that amount is, is you basically compare what is your one-year gain amount, which is really all what has been previously thought of as long-term capital gain or loss. So, one year gain amount, so gains and losses from assets that have been held for greater than one year. And you calculate your three-year gain amount, which is the gain or loss from the assets that have been held for greater than three years.
And the difference between the two is the recharacterized amount. So, the definitionally one year gain amount, API one-year distributors share amount is net long-term capital gain or loss allocated from all APIs held during the year. Excluding long-term capital gain or loss determined under Sections 1231 and 1256. Excluding qualified dividends and capital gains or losses that characterized as long term or short term without regard to the holding period rules of Section 1222.
So basically, we're looking for long-term capital gains or losses, but excluding any long-term capital gains or losses that are long term only because the code section tells us they're long term or short term, not because of the actual holding period. API on-year disposition amount is long-term capital gains or losses recognized during the taxable year on the disposition of all or a portion of the API. So, the sale of the partnership interest itself, not the underlying assets.
That has been held for more than one year, including amounts treated as gains or losses on disposition of partnership interest held for more than one year under Section 731(a). So, if there's distribution in excess of basis, that would be treated as gain under 731(a) that gets included into the disposition amount. And long-term capital gains or losses recognized on disposition of distributed API property that has a holding period of more than one year, but not more than three years to the distributee.
So, you can cleanse the API status or reclassification issue by just distributing property out of the partnership to the partners. So, any property that has been distributed in connection with API will continue to carry API taint and the gains need to be reclassified. So, that was the definition of a one-year date amount. The three-year date amount is API one-year distributive share amount less items that would not be treated as long-term capital gain or loss if the required holding period were three years instead of one.
So, saying it simply, take out the assets that were not held for more than three years out of your one-year gain amount, or out of your one-year distributive share amount, and you get to the three-year distributive share amount. So, that's the allocation of gain or loss from the underlying fund on the assets that were not held for more than three years. And then, the second piece of that is the API.
Three-year disposition amount is the long-term capital gains and losses recognized during the taxable year and the disposition of the API and trust that was held for greater than three years. If the one-year gain amount, right, if your total long term gain amount is zero or a loss, there is no recharacterization amount. If the three-year gain amount is zero or less, the three-year gain amount is zeros for purposes of calculating the recharacterized amount. So, there is suggestion of-
Bill Yahara:So, Irina, we had one fast question, it seems like we have a string of them. Are the recharacterization amounts required to be determined at the passthrough entity level or owner taxpayer level?
Irina Kimelfeld:So, they're reported all the way up the chain. And at the end of the day, they end up on the owner's tax return, right? But this is a reporting that goes all the way up the chain because APIs, they're at all the levels. So, there's additional consideration to the three-year disposition amount, this look-through rule.
So, what the IRS was concerned about is that if you set up general partners using an existing partnership with a holding period of at least three years, or forming entities in anticipation of receiving substantial capital gains in the past in advance to get to that three-year holding period faster. So, you essentially have more of a show entity, for lack of a better term, sitting there for two years.
And then, you hold on to it for another year when there's actual investing happening down the chain. And then, you sell it and you say, "Well, I have a three-year holding period." Right? So, that's what the IRS was concerned about. The proposed regulations included a limited look-through a rule, which is really look-through, meaning, looking through the chain to see how long have the assets actually been held, as opposed to just looking at the entity.
The limited look-through under the proposed regulation was applied 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, right? So basically, if 80% of the assets were three years or less, then they would need to be reclassification even if the partnership interest was held for more than three years. That look-through rule has been changed.
So, under the final regulations, the look-through rule applies when there is a sale of an API interest held for more than three years. The API would have a holding period of three years or less if the holding period of an unrelated non-service partner, here's that term again, that has an obligation to legally contribute a substantial amount of at least 5% of money or property to the passthrough entity, the API is related to does not exceed three years.
So basically, they're looking at other unrelated non-service partners if their holding period would have been less than three years, right? So, you formed this entity, you've had it. But you only took in investors last year, so their holding period would be less than three years. Then the look-through rule would apply, or a catch all, and to use general language, a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization.
So, anything that you can think of that is trying to get you to that holding period without really having substantial activity would basically kick you back into this look-through a rule. So, if the look-through rule does apply, then the three-year disposition amount is reduced by the seller's share of unrealized gains on the assets held for less than three years. So, this is really, as the name suggests, looking through how long have the assets been held. So, it doesn't really matter what the percentage is, right?
So, in the proposed regulations, it would only apply if there was 80% or more of assets for less than three years. You are now looking through in applying whatever that percentage of the assets held for less than three years, and treating those amounts as not three-year disposition amounts. So, I think we are really coming up to an hour really fast. So, I think we may skip over certain things like the related person transfers. We'll do another polling question to make sure that we do give CPE to people.
Bill Yahara:True. So, that was what I was expecting. Remember, on the proposed regs, they had the, under 7049(b), maintenance of capital. However, under the final regulations, it's capital contributor. So, great job, everyone. Next thing I want to talk about is the reporting requirements. We're going to go through pretty quick here. You can see that this is what needs to be really followed through on the K-1s.
But just remember in the final regulations, if an issue arise where an owner taxpayer does not receive the required information to substantiate its one- and three-year gains, in this situation, the greater than three-year gains are essentially lost. And any character that was a benefit to you may also be lost. So, Treasury feels that the zero assumptions are necessary to administer this part of the Regulations.
Move on, the effect on private equity. Just know historically, private equities, they hold their investments for five or seven years or even greater at certain times. But there could be early exits and follow-on investments bifurcated holding periods. And just a couple things, depending on all the facts and circumstances, they may be a potential for planning to set up a different acquisition vehicle to make follow-up investments.
Definitely talk to your attorney about doing that if you were to set something up that like that. Also, co-investment deals, there's an issue, the unrelated service provider meeting the 5% and where does the co-invest now put that? It's another thing that's open for debate, and we're expecting further information on that. But the carry waiver, final regulations did not address the waivers but the preamble to the proposed regulations contain the following language.
Taxpayers should be aware that they did mention it. But there could be further guidance released on that depending on your facts and circumstances and the way that you are setting up these carry waivers.
Irina Kimelfeld:I think on the carry waivers, just a second, sorry, similar to the proposed regulations or the regulations that were out there with respect to the management fee waivers, the concept of substantial entrepreneurial risk remains. So, if the carry waivers are considered, those concepts should be But it should be a real waiver, there should be no presumption of guaranteed further income or allocation of carry to the extent there's language in the agreements that talks about only taking carry out of three-year gains. It potentially could become problematic. But once again, depending on the level of uncertainty around actually recognizing those, the carry in the future years, and if it continues to be subject to significant intrapreneurial risk.
We think it would work, but the Regulations do not address it specifically. So presumably, we rely on all the other rules and doctrines that are out there to make sure they work.
Bill Yahara:So, the applicability dates, the final regulations generally apply to tax years beginning on or after the date the final regulations are published in the federal register. So, what does this mean essentially? To apply for tax years of the owner taxpayer starting in 2022. However, do remember that if you did rely on any part of these regulations that you're in the Regs now, and you would have to follow them. So, the effective date here would be for the 2022 tax year.
And also, consistent with the proposed regs, the rules for partnership interest held by S Corporations are effective for tax years beginning after December 31 2017. And the rules for partnership interest held by a PFICS that have made QEF election are effective for tax years beginning after August 14 2020. So, with that, what's next, Irina?
Irina Kimelfeld: Well, as we've been going through the things that the regulations do address, we've noted that there are things that the Regulations either have not addressed or we feel still could stand additional guidance. Most notably, the provision that the 1061 shall not apply to income or gain attributable to any asset not held for portfolio investments on behalf of third-party investors that small office exception that continues to be reserved.
So, we are thinking there is going to be guidance forthcoming on that. Treasury is studying whether there is a simple method that 1061 can be applied to small partnerships. So, we're thinking there is guidance forthcoming on that. We would love some additional clarity around the unrealized crystallized carry in the hedge fund scenarios that the Regulations did address but we don't think address specifically to hedge funds scenarios.
And there's continued to be discussions around what the guarantees in the context of loan-funded capital interest means and should they really be applied to disqualify the contributions as capital interest. There are some comments that have been made regarding the look-through rule, requesting that gain associated with goodwill or enterprise value retain the holding period for the partnership interest itself, as opposed to the underlying assets.
So, we're hoping those comments will be considered as well. As I mentioned in the beginning of the hour, a new proposed legislation has been proposed in the House of Representatives. And it basically is a throwback to the 2007 version of the proposed rules on the carried interest. It could recharacterize all the capital gains and losses as well as qualified dividends as ordinary income so no longer short-term capital and no longer three-year holding period, but straight-out ordinary income.
It would disallow 1202, qualified small business stock, treatment on the gains allocated to service providers. Similarly, recharacterize disposition gains as ordinary income. Similarly, to the 1061 in place, provides for capital interest exception. So, this is proposed and definitely uncertain of its future. But it's, as I mentioned, stays on top of the mind of the lawmakers. So, this potentially could be forthcoming.
And candidate Biden's proposals when he was running for president was to tax capital gains and dividends over a million dollars as ordinary income. So, those two could potentially interplay together and possibly, this carry legislation could become a compromise, leaving investors gains taxed at the preferential rate. But tax and carry is ordinary. So, stay tuned. I don't think this is a closed topic. So, potentially, more to come. There were quite a bit of questions.
We are five minutes over. So, there're quite a bit of questions. I hope we've addressed some in our presentation. But our emails are here. So, if anybody would like to continue to discuss, please feel free to reach out. We will go through these questions and reach out to you as well to the extent we can. Thank you very much for joining us. It's been a pleasure.
Transcribed by Rev.com
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Irina Kimelfeld provides tax planning and compliance services to private equity funds, hedge funds, funds of funds and other financial services companies.
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