In January 2021, the U.S. Department of Treasury and the Internal Revenue Service  released final regulations (the Final Regulations) under Section 1061 of the Internal Revenue Code of 1986, as amended (the Code).  Code Section 1061 was enacted in 2017 to place limits on the ability of carried interest arrangements to be eligible for preferential long-term capital gain  (LTCG) rates instead of higher ordinary income tax rates.  In general, equity issued in exchange for services is taxable at ordinary income rates unless that equity is a profits interest.  A carried interest is a form of profits interest that gives a service provider the right to share in future partnership profits but is not taxable upon receipt because it would not share in any distributions if the partnership liquidated immediately after the issuance of the profits interest. Under prior law, to the extent a partnership recognized LTCG from the sale of an underlying asset held more than one year, or the holder of a carried interest recognized LTCG from the sale of a carried interest held more than one year, a carried interest holder would be allocated or recognize LTCG even though the carried interest was originally issued as additional consideration  for services.

Code Section 1061 requires an “applicable partnership interest” (API) to meet a three year holding period requirement before the holder is eligible to recognize LTCG from the sale of the API or allocation of LTCG from the sale of the partnership’s assets.[1]  Despite this significant restriction on the ability of API holders to receive LTCG treatment, the Final Regulations do provide some taxpayer friendly changes that exclude certain interests and certain transactions from the three year holding period.  A few key takeaways from the Final Regulations are as follows:

• Real Estate Partnerships – In general, carried interests in partnerships that own capital assets are subject to the three year holding period of Code Section 1061. However, because of what many suspect is a drafting error, a Code Section 1231 asset is not subject to the extended holding period.  Most real estate assets are considered Code Section 1231 assets.  Therefore real estate partnerships with carried interest structures can often still receive LTCG treatment when exiting an investment prior to the end of the three year holding period if the partnership structures the exit event as a sale of the underlying real estate instead of a sale of the carried interest (the sale of a partnership interest is considered a capital asset and not a Code Section 1231 asset and thus is subject to the three year holding period).
• Capital Interest Exception – Code Section 1061 excludes from the API definition any capital interest in a partnership which provides the partner with a right to share in partnership capital pro rata with the amount of capital contributed or deemed contributed. Unlike the Final Regulations, the Code Section 1061 proposed regulations (“Proposed Regulations”) were significantly more restrictive with regards to the capital interest exception. The Proposed Regulations provided that the capital interest exception only applied if a capital interest allocation was  made “in the same manner” as allocations made to unrelated non-service partners with a significant (at least 5%) aggregate capital account.  The Final Regulations do not use the “same manner” test, and instead use a “similar manner” test under which the carried interest holder’s capital interest rights must be “reasonably consistent” with allocations made to third-party investors.
• Related Party API Transfers – Under Code Section 1061, once an API is classified as such, it remains an API.  The Proposed Regulations provided an exception in the case of a bona fide purchase by an unrelated taxpayer that would not provide services to the partnership.  However, the Proposed Regulations defined “transfer” broadly, so that it was unclear if non-taxable transactions like gifts would create API gain.  The Final Regulations define “transfer” to include only taxable transfers of APIs.

Potential Changes in Biden Tax Legislation

Congress has indicated that it desires to change the law to further “close” the carried interest “loophole” (i.e. any ability for a service provider to receive LTCG rates from a partnership interest acquired in exchange for providing services, and the deferral of some or all of the income until an exit event).[2]  Under this proposed bill, an API is treated as an interest free loan from cash investors to the API holder.  In other words, it treats the API holder as if it receives compensation currently in the amount of interest foregone on the deemed loan.  The deemed compensation would be taxed at ordinary rates.  Thus, the bill would prevent LTCG rates from applying to the API and the deferral of such gain until an exit event.

[1]   A full discussion of APIs is beyond the scope of this update, but in general, an API includes carried interests in a private equity investment partnership or a real estate development partnership (as well as other types of investment partnerships).

[2] See https://www.finance.senate.gov/chairmans-news/wyden-whitehouse-bill-ensures-private-equity-moguls-pay-fair-share-in-taxes.

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