IRS Releases Proposed Regulations on Recharacterization of Carried Interest

On July 31, 2020, the U.S. Internal Revenue Service (IRS) released proposed regulations (Proposed Regulations) applicable to the carried interest provision enacted as part of the 2017 Tax Cuts and Jobs Act, Section 1061 of the Internal Revenue Code of 1986, as amended (the Code).¹ Section 1061 recharacterizes certain long-term capital gains of a noncorporate partner that holds one or more applicable partnership interests (APIs) as short-term capital gains unless the gains are from assets held for more than three years. For a further description of Section 1061, see Congress Finalizes Tax Reform.

Once an API, Always an API

The Proposed Regulations clarify that once a partnership interest becomes an API, such interest will remain an API unless and until an exception applies. Therefore, a partnership interest will remain an API even if (i) the partner holding such interest is no longer providing services to the partnership, (ii) the partnership is no longer engaged in an applicable trade or business, or (iii) the API is contributed to another pass-through entity, trust, or estate. 

Practice Note. There is no exception for retiring partners or similar “good leavers” in a fund sponsor’s business.  

Substantial Services for Applicable Trade or Business   

For an interest to be an API, it must be transferred in connection with the performance of substantial services in an applicable trade or business (ATB), and the ATB must meet an “ATB Activity Test.” The Proposed Regulations provide a presumption that services are substantial, determine whether an ATB meets the ATB Activity Test by looking at all activities of related persons, delegates, and agents, and do not require that the ATB be conducted after an interest is considered an API. 

Practice Note. The broad approach to include related entities and services and to trace through tiered ownership structures will provide a broad application of Section 1061. 

Recharacterization Amount

The Proposed Regulations adopt a partial entity approach where the existence of an API is determined at the entity level but the recharacterization of the gain happens at the “Owner Taxpayer” level (the person subject to federal income tax on the net gain with respect to one or more APIs). An Owner Taxpayer nets gains and losses from all APIs (including any API held through a pass-through) before determining the Recharacterization Amount. 

Practice Note. The partial entity approach generally allows an Owner Taxpayer to offset gain from one API with loss from another API. This should be helpful for fund sponsors who set up different carry or incentive vehicles for each of their funds — for example, when there is a reversal of an incentive allocation from one API resulting in a short-term API loss.

Capital Interest Gains and Losses Exception

In general, allocation of gains attributable to a capital contribution made by a holder of an API are excluded from recharacterization. Such allocations of gains and losses (including through passthroughs) must meet the following requirements:

• They must be based on the relative capital accounts of the partners, and the terms, priority, type and level of risk, rate of return, and rights to cash or property distributions during the partnership’s operations and on liquidation must be the same, subject to carve-outs for preferred returns and reduced cost services (such as management fee “breaks”). 
• There must be allocations made to “unrelated non-service providers” (i.e., third-party investors) with a significant (5 percent or greater) aggregate capital account balance. 
• The partnership agreement and the partnership’s books and records must clearly segregate such allocations from allocations with respect to APIs.

Practice Note (allocations). The Proposed Regulations provide that an allocation will not fail to be a “capital interest allocation” because such allocation is not reduced by the cost of services by the holder of the API or a related person. This rule should allow an employee of an investment manager to not be subject to Section 1061 on a capital investment/capital interest (not otherwise funded through a loan from the sponsor or similar related party) in the fund even if such employee is not charged a management fee. The Proposed Regulations do not expressly include a waiver of carry or incentive allocations as a reduced cost of service, but such waivers ought to be considered as such.  

Practice Note (conversion of gain). Prior to the Proposed Regulations, there was some uncertainty whether unrealized capital gains with respect to an API could be converted into gains that would qualify as Capital Interest Gains and Losses not subject to recharacterization under Section 1061 through a recapitalization or division transaction treated as a Section 721 contribution (Recapitalization Transaction). The Proposed Regulations clarify that unrealized API gains cannot be converted into gains that qualify as Capital Interest Gains and Losses under a Recapitalization Transaction; however, if there is a Recapitalization Transaction in respect of realized API gains, the appreciation on such recapitalized amount ought to qualify as Capital Interest Gains and Losses. It is still unclear from the Proposed Regulations whether appreciation on realized API gains will qualify as Capital Interest Gains and Losses when there is no Recapitalization Transaction.

Exceptions to What Is an Applicable Partnership Interest

• Corporate Exception. An API does not include any interest in a partnership that is directly or indirectly held by a corporation. The Proposed Regulations provide that neither S corporations nor passive foreign investment companies (PFICs) whose shareholders have qualified electing fund (QEF) elections in effect are “corporations” that benefit from this exception.
• S corporations: Consistent with the Notice 2018-18 issued on March 19, 2018, the Proposed Regulations provide that the term “corporation” does not include an S corporation. This rule applies to taxable years beginning after December 31, 2017. 
• PFICs With QEF Elections: The Proposed Regulations provide that the term “corporation” does not include a PFIC when a shareholder has made a QEF election under Section 1295. This rule applies to taxable years beginning after the date of publication of the Proposed Regulations in the Federal Register.  

Practice Note. Taxpayers have questioned whether the IRS has authority to interpret “corporation” to exclude S corporations and PFICs or whether Congress would need to amend 1061. In addition, a PFIC can be materially distinguished from an S corporation as a PFIC is subject to withholding tax on certain U.S. source income and may be subject to entity-level tax in case of any effectively connected income in respect of a U.S. trade or business. Thus, it is possible that objections may be raised in public comments against the exclusion of PFICs. 

Non-ATB Employee. Section 1061(c)(1) provides that an API is not held by a person who is employed by another entity that is conducting a trade or business, other than an ATB, and provides services only to such other entity. The Proposed Regulations track the language of the statute. 

Bona Fide Unrelated Purchaser Exception. The Proposed Regulations add a new exception that applies to bona fide unrelated taxpayers who purchase an API for the fair market value of the interest. However, the exception does not apply to an unrelated non-service provider who becomes a partner by making a contribution to a passthrough entity that holds an API and in exchange receives an interest in the passthrough entity’s API.

Practice Note. Noncorporate investors in fund managers will need to think about structuring options to mitigate the consequences of the proposed “Once an API, Always an API” rule.

Gain Not Attributable to Third-Party Investors. Section 1061(b) provides regulatory authority to establish an exception for gain attributable to any assets not held for portfolio investment on behalf of third-party investors. The Proposed Regulations reserve on the exercise of that authority while acknowledging comments that this exception was intended to cover family offices.

The Applicable Holding Period 

The Proposed Regulations generally provide that the holding period of the owner of the asset sold is the applicable holding period. Thus, if a partnership disposes of an asset, the partnership’s holding period controls — for example, if a fund sells a security it has held for more than three years, the gain from the sale will satisfy the three-year holding period requirement under Section 1061 for all taxpayers allocated a portion of the gain from the sale, including a taxpayer who has held an interest in the general partner of the fund (and received a share of the profits interest) for less than three years

Practice Note (carried interest waivers). Carried interest waivers allow the carry recipient of a fund to waive or defer capital gains from investments that have not been held for more than three years and receive “makeup” allocations of long-term capital gains from future profits. The Proposed Regulations do not address the use of carried interest waivers, but the IRS in the preamble to the Proposed Regulations warns that taxpayers should be aware that the use of carried interest waivers to effectively avoid Section 1061 may not be respected and may be challenged under pre-existing law.    

Gains Excluded From Section 1061

Gains that do not rely on the greater than one year holding period for capital gains under Section 1222 are not subject to recharacterization under Section 1061. All of the following retain their character when allocated to the holder of an API: (i) long-term capital gain or losses under Section 1231 (relevant for funds that invest in depreciable property); (ii) long-term capital gain or losses under Section 1256 (relevant for funds that invest in certain futures and options contracts); (iii) qualified dividend income (relevant for equity funds); (iv) any capital gain or loss that is characterized as long-term or short-term without regard to the holding period rules in Section 1222 (relevant for funds that invest in mixed straddle sales); (v) certain gains and losses the Owner Taxpayer may elect to exclude from Section 1061 as transition amounts; and (vi) long-term capital gain or loss from the disposition of property distributed in-kind that has a holding period of more than three years.

REIT and RIC Capital Gain Dividends

The Proposed Regulations allow for long-term capital gain treatment with respect to real estate investment trust (REIT) and regulated investment company (RIC) capital gain dividends to the extent that such capital gain dividend is attributable to capital assets held for more than three years or is attributable to assets that are not subject to section 1061 provided appropriate information is provided by the REIT or the RIC to support such treatment.

Interest in a Partnership

The Proposed Regulations provide that solely for purposes of Section 1061, an interest in a partnership also includes any financial instrument or contract, the value of which is determined, in whole or in part, by reference to the partnership.
Practice Note. An API could be issued in differing types of compensatory arrangements even if no legal entity interest is issued and possibly, in seeding arrangements.

Practice Note. An API could be issued in differing types of compensatory arrangements even if no legal entity interest is issued and possibly, in seeding arrangements.

Gains on the Sale of APIs and Distributed API Property

For purposes of Section 1061, the determination of whether capital gain or loss that an Owner Taxpayer recognizes from the direct taxable disposition of an API is short term or long term will generally be determined by the holding period the Owner Taxpayer has in the API. However, the Proposed Regulations provide two exceptions even when the Owner Taxpayer’s holding period of the API is more than three years:

• Substantially All Test (80 Percent Test). The holding period will be the underlying partnership’s holding period in the partnership’s assets if 80 percent or more of the underlying partnership assets have a holding period of three years or less and that, if sold, would not give rise to gain excepted from Section 1061.
• Sale of Interest in Tiered Partnership. Gain from the sale of an upper-tier partnership interest will be recharacterized under 1061 if such upper-tier partnership has a less than three-year holding period in the API.   

Long-term capital gain or loss recognized on the disposition of property distributed to a holder of an API with respect to such API (Distributed API Property) will be short-term capital gain under Section 1061 if the holding period in the Distributed API Property is three years or less (inclusive of the partnership’s holding period). 

Practice Note. The Proposed Regulations do not prohibit an Owner Taxpayer from holding Distributed API Property for more than three years, taking into account any carryover holding period, before disposing of the same and recognizing long-term capital gain. 

Transition Rule

A partnership that was in existence as of January 1, 2018, may irrevocably elect to treat all long-term capital gains and losses from the disposition of all assets that were held by the partnership for more than three years as of January 1, 2018, regardless of whether they would be attributable to an API, as amounts not subject to Section 1061. 

Taxpayers may rely on this rule from the Proposed Regulations to make the election for taxable years beginning in 2020 or in a later year before the final regulations are published.

Transfers to Related Parties

Under Section 1061(d), if a taxpayer transfers an API to a related person (generally, family members, coworkers, and entities that provide services) in a transfer that would not otherwise be a taxable event, the taxpayer must include certain capital gain in gross income as short-term capital gain. The amount included as short-term capital gain is the excess of the net built-in long-term capital gain in assets held for three years or less attributable to the transferred interest, over the amount of long-term capital gain recognized on the transfer that is treated as short-term capital gain under Section 1061(a). Any such taxable amount increases the tax basis of the transferee. The term “transfer” under the Proposed Regulations includes, but is not limited to, contributions, distributions, sales and exchanges, and gifts. Contributions under Section 721 are not subject to this rule as built-in gain is generally allocable to the transferor partner.

The rules provided in the Proposed Regulations generally will apply to taxable years beginning on or after the date final regulations are published in the Federal Register. Taxpayers may rely on the Proposed Regulations for taxable years beginning before the date final regulations are published in the Federal Register provided they follow the Proposed Regulations in their entirety and consistently. 

Taxpayers may rely on the rules in the Proposed Regulations regarding a partnership’s ability to elect to treat certain long-term capital gains and losses as amounts not subject to Section 1061 for taxable years beginning in 2020 and subsequent taxable years beginning before the date final regulations are published in the Federal Register.