Editor: Susan Minasian Grais, CPA, J.D., LL.M.
This item discusses proposed regulations that the IRS issued on July 31, 2020, regarding the tax treatment of carried interests (REG-107213-18). [Editor's note: The IRS finalized these regulations in January 2021 with a few changes (T.D. 9945). See news coverage of the final regulations here.]
The law known as the Tax Cuts and Jobs Act, P.L. 115-97, modified the taxation of carried interests by enacting Sec. 1061. This Code provision generally says that to qualify for tax-favored long-term capital gains (LTCGs) treatment, certain carried interest arrangements must meet a greater-than-three-year holding period requirement. The new rule applies to carried interests in many private-equity and alternative asset funds (i.e., hedge, real estate, energy, infrastructure, and fund of funds). Where it applies, Sec. 1061 recharacterizes LTCGs arising from the sale of capital assets held for more than one year, but not more than three years, as short-term capital gains (STCGs), which are typically taxed at the rates applicable to ordinary income.
The proposed regulations would:
- Provide that certain types of capital gain income are not subject to Sec. 1061's greater-than-three-year holding period requirement, including:
- Qualified dividend income;
- Sec. 1231 gains;
- Sec. 1256 gains;
- Other gains characterized as long-term without regard to Sec. 1222 (e.g., capital gains and losses identified as mixed straddles under Sec. 1092(b) and certain regulations promulgated thereunder); and
- Real estate investment trust (REIT) and regulated investment company (RIC) capital gain dividends and certain LTCG inclusions from a passive foreign investment company (PFIC) with respect to which a qualified electing fund election has been made, to the extent it is attributable to REIT/RIC/PFIC income that does not arise from the sale of capital assets held for one-to-three years (provided certain reporting requirements are met);
- Apply complex reporting requirements for partnerships, including funds;
- Create a new third-party purchaser exception;
- Adopt a "partial entity" approach whereby passthrough entities would be treated as taxpayers for purposes of determining the existence of a carried interest subject to Sec. 1061 but not for purposes of recharacterizing LTCGs as STCGs;
- Specify that gain from a sale of property distributed with respect to a carried interest may be subject to Sec. 1061; and
- Clarify that the holding period of the asset being sold is determinative, subject to certain exceptions for transfers of interests in passthrough entities.
Although the preamble to the proposed regulations cautions taxpayers regarding carry waivers, the regulations would not impose new restrictions or guidelines regarding these waivers.
Note, finally, that carried interests are referred to in Sec. 1061 as applicable partnership interests (APIs). Below is a more detailed examination of specific features of the proposed regulations, after a brief discussion of effective dates.
The regulations would apply to tax years beginning on or after the date final regulations are published in the Federal Register, subject to limited exceptions related to profit interests held by S corporations and certain PFICs, topics that are discussed below. Taxpayers generally may rely on the proposed regulations before they are published in final form, provided they follow the regulations in their entirety and in a consistent manner. (Taxpayers may rely on the proposed regulations' rules on partnership transition amounts and API holder transition amounts for tax years beginning in 2020 (and subsequent tax years), even without consistently following all the requirements of the regulations.)
Carried interests issued to corporations
The proposed regulations contain certain important exceptions. Under a corporate exception, APIs held directly or indirectly by corporations are not subject to Sec. 1061's greater-than-three-year holding period requirement. For purposes of this exception, the proposed regulations would provide that an S corporation is not considered a corporation, consistent with Notice 2018-18. (The proposed regulations provide that the S corporation exclusion applies to tax years beginning after Dec. 31, 2017.) The proposed regulations would also exclude from the corporate exception APIs held by PFICs for which a qualified electing fund (QEF) election was made. The rule for a QEF holding an API would be effective from the date the regulations are published in the Federal Register.
Practice note: Certain funds, such as credit funds that generate significant ordinary income or that qualify for the trading safe harbor, may hold their carried interests in C corporations — such interests are not treated as APIs.
Employees of certain entities
Another exception relates to employees of entities that are not engaged in an applicable trade or business (ATB). The proposed regulations track the statutory language for this exception.
Practice note: This exception has been interpreted to cover persons receiving profits interests for providing services to portfolio companies engaged in operating trades or businesses.
Bona fide third-party purchaser
The proposed regulations also would create an exception to Sec. 1061 for bona fide third-party purchasers. The new exception would generally provide that an API will cease to be treated as an API if it is purchased by a person who does not currently provide, did not provide, and does not anticipate providing services to the partnership or any lower-tier partnerships; is unrelated to any service provider (including service providers with respect to any lower-tier partnerships); and acquires the interest in a fully taxable transaction for fair market value (FMV). However, the exception would not apply if the Sec. 1061(d) rules regarding transfers of APIs to related persons apply to the transfer in question.
Practice note: This exception is generally expected to permit certain unrelated institutional investors to acquire interests in the general partner without any adverse consequences under Sec. 1061, subject to the discussion below under fund-specific industry implications.
The family office exception
An exception found in Sec. 1061(b) is somewhat difficult to decipher. It provides that, "[t]o the extent provided by the Secretary, [Sec. 1061(a)] shall not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors." The proposed regulations reserve on this exception. The preamble notes that many comments suggested that this exception was intended to apply to family offices; significantly, the preamble also states that Treasury and the IRS generally agree with those comments and believe that the Sec. 1061(b) exception effectively is implemented as part of the regulations' provisions under the capital interest exception. However, the proposed regulations do not mention this family office exception, and it is not entirely clear whether the proposed regulations' capital interest exception provisions will exempt most, or all, family office structures. It is hoped that this exception will be clarified when the regulations are finalized.
Sec. 1061 computations
Partnership allocation mechanics — partial-entity approach: The proposed regulations contain certain rules for making Sec. 1061 computations. First, they adopt a hybrid approach to allocations made with respect to APIs, referred to as the partial-entity approach. Under this approach, partnerships and other passthrough entities are treated as taxpayers for purposes of determining the existence of an API but not for purposes of recharacterizing LTCGs as STCGs. The recharacterization amountis determined not at the partnership level but only at the level of the ultimate owners (individuals, estates, or trusts).
In applying Sec. 1061's recharacterization rule to gain on the sale or exchange of an asset, the holding period of the asset disposed of generally controls. For example, if a fund sells stock of a portfolio company, the relevant holding period is the fund's holding period in the portfolio company stock — not the general partnership entity's holding period in its carried interest in the fund or an individual carry partner's holding period in its interest in the general partnership entity. On the other hand, if a partner recognizes gain from the sale or exchange of an API (including gain due to an excess distribution under Sec. 731(a)), the relevant holding period is generally the partner's holding period in the API; however, this rule is subject to important exceptions under the lookthrough rule and Sec. 1061(d) (both discussed below).
The lookthrough rule: As stated above, in general, the relevant holding period under the proposed regulations for applying the greater-than-three-year rule is the holding period of the asset disposed of. However, the proposed regulations include a limited lookthrough rule, which under certain circumstances would recharacterize greater-than-three-year capital gain on a partnership interest disposition as one-to-three-year capital gain if the underlying assets have a holding period of not more than three years.
Property distributions with respect to an API interest: The proposed regulations contain a special rule for property distributed with respect to an API. Under this rule, the distribution does not accelerate gain recognition under Sec. 1061 or the regulations, but a gain or loss from a subsequent sale or exchange of such property will be taken into account under Sec. 1061 if, at the time of the disposition, the distributee partner's holding period in the property is not greater than three years. For example, if a fund distributes stock with a two-year holding period to a partner, the distributee partner will generally take the same two-year holding period in that stock under Sec. 735(b). If the distributee partner then sells the distributed stock within a year of receiving it (i.e., while it still has a holding period of not more than three years), the gain would be treated as API gain under the regulations.
Bifurcated holding periods of APIs and profits interest: Generally speaking, Sec. 1061 and the proposed regulations do not supplant the existing rules for determining a partnership's holding period. Nor do they supplant the existing rules for determining a partnership's tax basis in its partnership interest. A partner generally has a single, unitary basis in its partnership interest and a single Sec. 704(b) book capital account, even though the partner may hold multiple different classes of interest in the partnership.
Where a partner disposes of only part of its partnership interest, the partner must equitably apportion the tax basis of the entire interest between the portion of the interest that is disposed of and the portion of the interest that is retained. In addition, where a partner acquires multiple interests in a partnership at different times (or in exchange for the contribution of assets with different holding periods), the partner may have a split holding period in its partnership interest. If a partner has a split holding period in its partnership interest and the partner disposes of only part of its interest, then, unless the partnership is a publicly traded partnership, the portion of the interest disposed of and the portion of the interest retained will each have a split holding period.
The proposed regulations generally leave the above-described regime undisturbed, except for a proposed modification to the regulations under Sec. 1223 that would apply for purposes of determining the holding period of a partnership interest that consists in whole or in part of one or more profits interests. Under this rule, the portion of the holding period to which a profits interest relates is determined based on the FMV of the profits interest at the time that all or part of the partnership interest is disposed of.
Transfers to related persons
If an owner taxpayer transfers an API, or property distributed with respect to an API with a holding period of not more than three years, to a "related person," the proposed regulations under Sec. 1061(d) apply. For purposes of Sec. 1061(d), the regulations would define "related person" to include family members, persons who provide (or recently provided) services in the relevant trade or business, and passthrough entities in which such persons own direct or indirect interests. These rules may (1) turn a transaction otherwise eligible for nonrecognition into a taxable transaction and/or (2) result in the recharacterization of LTCGs into STCGs. "Transfer" for this purpose includes contributions, distributions, sales, exchanges, and gifts. This aspect of the proposed regulations may affect some wealth planning strategies.
Reporting considerations: The proposed regulations have implications for funds and the managers and general partners of such funds. Funds may find certain aspects of the new rules challenging, such as the capital interest definition, the reporting requirements, and the lookthrough rule.
Carried interest waivers: The preamble mentions tax planning techniques commonly referred to as "carry waivers." A carry waiver generally refers to a transaction in which a carried interest holder waives its right to a carried interest distribution, and the accompanying allocation of taxable income, in exchange for the right to receive a potential future distribution and allocation of income from the partnership, contingent on the fund's earning sufficient future income to make the allocation. The income waived is generally of a character disadvantageous to the carried interest holder, such as gain from the sale of a capital asset held for not more than three years. The preamble cautions that carry waiver strategies may be challenged under various grounds, including the partnership anti-abuse rule in Regs. Sec. 1.701-2 and the economic substance doctrine. However, the proposed regulations do not include new rules on carry waivers.
Capital interest exception considerations: Under Sec. 1061, an API does not include certain capital interests. The general partner of a fund may earn a limited-partner-like economic return on its partnership capital account attributable to prior carried interest allocations (sometimes referred to as a return on proprietary capital). This arrangement is particularly common in the hedge fund industry. The statute appears to predicate the applicability of the capital interest exception on a prior capital contribution or Sec. 83 income inclusion. Accordingly, it was unclear under the statute whether a general partner's return on its proprietary capital would be eligible for the capital interest exception. The proposed regulations suggest that it is. The portion of the regulations dealing with the capital interest exception does not require a capital contribution or Sec. 83 income inclusion but instead focuses on the manner in which partnership allocations are made.
The proposed regulations' requirement that allocations be made "in the same manner" to all partners to qualify under the capital interest exception may raise questions regarding common arrangements in the asset management industry. Frequently, capital interests held by the general partner or its affiliates do not receive allocations identical to the allocations made to unrelated investors. For example, the general partner and affiliates typically do not owe management fees or carried interests.
Moreover, many funds use side pockets or in certain cases may have transfers of interests that result in variations in allocations between API holders and non-API holders in a tax year (e.g., Sec. 706). In addition, the liquidity rights and other economic terms may differ in some respects. In such cases, it is not clear that allocations to the general partner and affiliates will meet the requirements of the capital interest exception set forth in the regulations. The only exceptions set forth in the regulations are that allocations to an API holder may be subordinated to allocations to unrelated non-service partners and that an allocation to an API holder need not be reduced by the cost of services provided by the API holder or a related person to the partnership. The apparent strictness of these requirements raises the possibility that capital interest allocations to service providers in many funds may fail the capital interest exception.
Related-person loan funded capital interest: Many partners are likely to be affected by the rule in the proposed regulations providing that a partner's capital account for purposes of the capital interest exception does not include any contributions funded by proceeds of a loan made or guaranteed by any other partner, the partnership, or a person related thereto. Where a deal professional receives a carried interest and commits capital in exchange for a capital interest but uses a loan that is made or guaranteed by the fund to finance this capital contribution, such capital interest is excluded from the definition of capital interest. The partner may obtain a qualified capital account by paying down the loan, unless such payments are funded by another disqualified loan. Investment professionals who fund their capital commitments through disqualified loans should consider alternative funding arrangements to address the proposed regulations' implications.
Third-party purchaser exception and tiered structures: As discussed above, the proposed regulations create an exception to API treatment where an unrelated non-service provider purchases an API in a fully taxable transaction. However, it is not totally clear how this exception applies in a tiered partnership structure. For example, it is unclear whether, if a third-party buyer acquires an API in a tiered partnership structure, the exception will apply not only to the API directly acquired by the buyer but also to the buyer's share of any APIs in any lower-tier passthrough entities.
Similarly, the proposed regulations do not specify whether the exception will also apply to any indirect interests in APIs that are acquired after the purchase (e.g., if a buyer purchases an interest in a general partner entity and, after the purchase, a new fund is formed and issues a carried interest to the general partner entity).
Passive foreign investment companies subject to a QEF election: Qualified electing fund (QEF) LTCG inclusions may be eligible for LTCG treatment under Sec. 1061, provided that the QEF satisfies certain reporting requirements. However, the QEF is not statutorily required to report such information to its owners or the IRS. Funds or other persons planning to invest, directly or indirectly, in passive foreign investment companies (PFICs) should consider negotiating for the contractual right to receive the additional information needed to comply with Sec. 1061 and thereby avoid converting Sec. 1061 exempt greater-than-three-year capital gains into one-to-three-year capital gains (the same applies to investors in certain funds or a fund of funds, in their side letters).
Wealth planning: Fund managers often seek to gift carried interests as part of their wealth and estate transfer planning. However, the related-person transfer rules in the proposed regulations cause gain to be accelerated — and taxed at STCG rates — upon a transfer to certain related persons (e.g., family members, certain family partnerships), even where the transfer would otherwise qualify as a nonrecognition transaction.
Add-on investments: The proposed regulations do not provide guidance on split holding periods related to add-on investments in portfolio companies structured as C corporations or partnerships. When making add-on investments, funds should carefully analyze the tax consequences of different potential structures to avoid or mitigate potentially adverse holding period consequences that could result in additional STCGs under Sec. 1061.
Susan Minasian Grais, CPA, J.D., LL.M., is a managing director at Ernst & Young LLP in Washington, D.C..
For additional information about these items, contact Ms. Grais at 202-327-8788 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.