IRS issues final rules on the treatment of carried interests

The IRS posted final regulations (T.D. 9945) on the tax treatment of carried interests under Sec. 1061. In response to comments, the final regulations make changes to the proposed regulations (REG-107213-18) that were issued in August 2020.

A carried interest (referred to in the regulations as an applicable partnership interest (API)) is defined as an interest in a partnership that is transferred to or held by a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or any other related person, in an applicable trade or business. To prevent owners of APIs from having the income they receive from an API taxed as capital gains income, the law known as the Tax Cuts and Jobs Act, P.L. 115-97, added Sec. 1061, which recharacterizes certain net long-term capital gain with respect to APIs as short-term capital gain.

The final regulations retain the basic structure of the proposed regulations with certain changes made in response to comments. Regs. Sec. 1.1061-1 provides definitions of the terms used in the final regulations. Regs. Sec. 1.1061-2 provides rules and examples regarding APIs and applicable trades or businesses. Regs. Sec. 1.1061-3 provides guidance on the exceptions to the definition of an API, including the capital interest exception. Regs. Sec. 1.1061-4 provides guidance on the computation of the recharacterization amount and gives computation examples. Regs. Sec. 1.1061-5 provides guidance regarding the application of Sec. 1061(d) to transfers to certain related parties. Regs. Sec. 1.1061-6 provides reporting rules.

Changes from the proposed regulations made in the final regulations include amendments to (1) the capital interest exception in Regs. Sec. 1.1061-3; (2) the treatment of capital interests acquired with loan proceeds; (3) the lookthrough rule for certain API dispositions; and (4) the treatment of transfers of APIs to Sec. 1061(d) related persons. Because the application of the Sec. 1061 rules requires a clear determination of the holding period of a partnership interest that is, in whole or in part, an API, the final regulations also provide clarifying amendments to Regs. Sec. 1.1223-3, which governs partnership-interest holding periods. The regulations also make clarifying amendments to Regs. Sec. 1.702-1(a)(2), regarding partners’ distributive shares of partnership capital gains and losses, and Regs. Sec. 1.704-3(e), providing that a method for aggregating gains and losses by a securities partnership will not be considered reasonable unless it takes into account the application of Sec. 1061.

The regulations generally apply to tax years of owner-taxpayers and passthrough entities beginning on or after Jan. 19, 2021, the date they were published in the Federal Register. Regs. Sec. 1.1061-3(b)(2)(i) (regarding an S corporation for which an election under Sec. 1362(a) is in effect) applies to tax years beginning after Dec. 31, 2017.

Regs. Sec. 1.1061-3(b)(2)(ii) (regarding a passive foreign investment company with a qualifying electing fund election in effect) applies to tax years beginning after Aug. 14, 2020.

Owner-taxpayers or passthrough entities may choose to apply the final regulations in their entirety to a tax year beginning after Dec. 31, 2017, if they consistently and entirely apply the final regulations to that year and all later years.