The U.S. Treasury Department and the Internal Revenue Service recently released proposed regulations under Section 1061 of the Internal Revenue Code of 1986, as amended.1 Congress enacted Section 1061 in 2017 in order to limit long-term capital gains treatment for certain “carried interests” by requiring a three-year (rather than one-year) holding period for the preferential rates applicable to long-term capital gains. Specifically, Section 1061 requires a taxpayer holding an “applicable partnership interest” or "API" in a partnership to recalculate its share of long-term capital gains from sales of partnership capital assets and its long-term capital gains from sales of APIs by applying a three-year holding period, rather than the general one-year period. To the extent that the longer three-year holding period is not satisfied, such capital gains are treated as short term rather than as long-term capital gains currently eligible for reduced tax rates.
In many respects, the proposed regulations are a welcome confirmation that Section 1061 should be applied in accordance with a plain reading of the statute and consistently with long-standing partnership tax principles. As discussed in more detail below, favorable aspects of the proposed regulations include:
- If a partnership disposes of an asset it has held for more than three years, the gain generally qualifies as more than three-year gain even if an API holder does not have a more than three-year holding period in its API.
- The proposed regulations do not restrict the use of properly structured waivers of less than three-year gains to mitigate the impact of Section 1061.
- Qualified dividend income and long-term capital gains from investments in most real estate assets are not subject to the three-year holding period requirements.
- Partnerships that invest through REITs can apply Section 1061 by “looking through” the REIT and therefore avoid Section 1061 for most real property gains earned through the REIT.
- Although gain from an asset distributed in kind to an API holder remains subject to the three-year holding period requirement, the holder can generally include the partnership’s holding period in the distributed asset.
- Carried interest held through a corporation is not treated as an API unless the corporation is an S corporation or a PFIC subject to a QEF election; notably, carried interest held through a REIT is excluded from API treatment.
Unfortunately, however, a number of provisions are either unnecessarily expansive or unduly restrictive — perhaps even unworkable. Potentially problematic aspects include:
- The expansive definition of APIs subject to Section 1061 potentially covers more than just typical “carried interests.”
- The exception for capital interests is so restrictive that it does not cover most capital investments and, absent changes, may cause many co-investment and similar interests to be subject to Section 1061.
- The related party rules may require short-term gain recognition in connection with certain restructurings of carried interest arrangements that would otherwise be eligible for deferral.
We hope that final regulations will take a more reasonable approach on those matters.
APIS SUBJECT TO SECTION 1061
The proposed regulations generally follow the statute in defining an API as a partnership interest transferred to or held by a taxpayer in connection with the performance of substantial services by the taxpayer (or a related person) in any “applicable trade or business.” An ATB is broadly defined to include raising or returning capital and investing in, disposing of or developing “specified assets” (generally, securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing) at a level of activity generally sufficient to establish a trade or business for tax purposes. The proposed regulations include a presumption that services are substantial if a partnership interest is transferred in connection with the performance of services. When APIs are held through tiers of partnerships, the proposed regulations provide rules for how gains and losses attributable thereto are to be allocated through the tiers and reported by the ultimate person subject to U.S. federal income tax in respect of the API. In addition, absent limited exceptions, the proposed regulations provide that once an interest qualifies as an API, the interest will always be treated as an API.
Observation(s): As expected, the proposed regulations’ definition of API captures typical carried interests in commingled investment funds. However, the broadly defined term also potentially includes interests that were not necessarily intended to be covered by Section 1061. It does not appear that APIs are limited to interests in partnerships that hold direct or indirect interests in the specified assets that are used in the ATB, so that, for example, interests in a management company that performs services for a fund in exchange for fees could be treated as APIs.
NARROW EXCEPTION FOR CAPITAL INTERESTS
Section 1061 provides that an API generally does not include a capital interest in a partnership that provides a right to share in partnership capital commensurate with the amount of capital contributed. Such a carve-out is needed so that the scope of Section 1061 remains consistent with the underlying policy of taxing carried interests, but not other partnership interests, at higher rates comparable to the ordinary income rates generally applicable to other forms of compensation. The proposed regulations refer to items excluded under the capital interest exception as “Capital Interest Gains and Losses.”
Unfortunately, the proposed regulations adopt a surprisingly limited definition of excluded Capital Interest Gains and Losses. As currently drafted, Capital Interest Gains and Losses (including such amounts allocated through passthrough entities) and amounts attributable to the disposition of a capital interest are excluded from Section 1061 only if the allocations to the capital interest held by the holders of APIs are made in the same manner, based on relative capital account balances, as they are made to unrelated non-service providers who hold at least 5% of the aggregate capital account balance of the partnership. Certain limited adjustments to these allocations are permitted (e.g., for management fees that are not charged on a fund sponsor’s commitment or because an allocation to an API is subordinated to an allocation to an unrelated non-service provider). This narrow definition of a capital interest is inconsistent with the economic arrangement among many partners, and many partnership agreements do not make allocations based on capital accounts, raising significant questions about the extent to which gains and losses from sponsor capital commitments and co-investments can be excluded from the Section 1061 regime if the proposed regulations are finalized in their current form.
In addition, the proposed regulations provide that capital contributions funded by a loan or other advance made or guaranteed, directly or indirectly, by any other partner or the partnership (or any related person with respect to any such other partner or the partnership) are not treated as part of the capital account balance of the borrower until principal payments are made. Accordingly, capital commitments funded through a loan arrangement may not be eligible for the capital interest exception.
Observation(s): The exception for capital interests is so restrictive that it does not cover most capital investments and, absent changes, may cause many co-investment and similar interests to be subject to Section 1061.
RELEVANT HOLDING PERIOD FOR DETERMINING THREE-YEAR GAIN UPON A SALE OF PROPERTY BY A PARTNERSHIP
Under general partnership tax rules, the partnership’s holding period in an asset, rather than a partner’s holding period in its partnership interest, determines whether the partner’s share of gain from the sale of the asset is long term or short term. In the case of sales of capital assets by partnerships, practitioners were concerned that the IRS might exercise its regulatory authority to condition an API holder’s long-term capital gain treatment on the partner having a more than three-year holding period for the partner’s API. However, consistent with a plain reading of the statute, the proposed regulations generally follow existing partnership tax principles and look to the holding period of the direct property owner in determining whether the three-year requirement has been satisfied. Thus, if a partnership disposes of an asset it has held for more than three years, the gain generally qualifies as a more-than-three-year gain even if an API holder does not have a more-than-three-year holding period in its API.
Despite this general principle, the proposed regulations include a “look-through rule” that may recharacterize as short term certain gains that would otherwise qualify as more-than-three-year gains. This look-through rule applies if:
- A partner sells a directly held API with a holding period of more than three years, but 80% or more of the assets of the partnership have been held for three years or less (the “substantially all” test), excluding assets that, if sold, would not generate gains otherwise subject to recharacterization under Section 1061 (e.g., Section 1231 gains, as discussed below); or
- In the case of a tiered structure in which an API is held through one or more passthrough entities, the API holder disposes of a passthrough interest held for more than three years and such passthrough entity has a holding period in the API of either (i) three years or less or (ii) more than three years but the assets of the partnership in which the API is held meet the Substantially All Test.
Observation(s): The look-through rule does not apply to the sale of partnership interests that are not APIs. Thus, for example, if an investment fund sells a lower-tier partnership interest that is not an API and has a holding period of more than three years, gain recognized by the fund on the disposition of the lower-tier interest would generally be treated as long-term capital gain, regardless of whether the lower-tier partnership holds predominantly assets that do not have more-than-three-year holding periods.
Commentators had considered whether a taxpayer could avoid the application of Section 1061 by receiving an in-kind distribution with respect to an API. However, the proposed regulations provide that if a partnership distributes property with respect to an API and the property does not have a more-than-three-year holding period, the distributed property must be held by the API holder for the remaining amount of the three-year holding period in order to avoid recharacterization under Section 1061.
Observation(s): While taxpayers cannot avoid the application of Section 1061 by receiving an in-kind distribution with respect to an API, the API holder can generally include the partnership’s holding period in the distributed asset.
CARRY ALLOCATION WAIVERS
After the enactment of Section 1061, many carried interest holders have sought to mitigate its impact by drafting partnership agreements to permit the waiver of allocations of gains that would otherwise be recharacterized as short term under Section 1061 in exchange for future “catch-up” allocations of more-than-three-year gains. The preamble to the proposed regulations acknowledges the practice and cites a string of general, long-standing, anti-abuse, and partnership allocation rules for the proposition that such arrangements “may be challenged.” The proposed regulations themselves, however, impose no additional hurdles on waiver arrangements.
Observation(s): While the preamble statements referenced above may be a notice of heightened audit risk, in our view the standards for whether waivers should be respected remain unchanged.
By its terms, Section 1061 applies to capital gains arising from the sale or exchange of “capital assets” that are treated as long term or short term by reference to the holding period rules under Section 1222. Long-term capital gains may arise under other sections of the Code as well — including notably (i) under Section 1231 in the case of gains from sales or exchanges of real property or other property of a character that is subject to the allowance for depreciation used in a trade or business and held for more than one year and (ii) under Section 1(h) in the case of qualified dividend income. Practitioners were concerned that the IRS might seek to extend Section 1061 to cover such items (at least to the extent they arise from investments in specified assets). As hoped, the proposed regulations clarify that long-term capital gains arising under Sections 1231 and 1(h) (as well as certain other sections of the Code not dependent on the holding period rules of Section 1222) are not subject to recharacterization under Section 1061.
Observation(s): Taxpayers should keep in mind that an API is treated as a capital asset and gain on a sale of an API is subject to Section 1061 notwithstanding the extent to which the underlying partnership holds Section 1231 property or other property giving rise to excluded gains.
EXCLUSION FOR APIS HELD BY CERTAIN CORPORATIONS
Section 1061 does not apply to partnership interests held by “corporations.” In prior guidance, the IRS restricted the scope of this exception by providing that S corporations are not treated as corporations for purposes of this rule. Like S corporations, passive foreign investment companies with respect to which the applicable shareholder has a qualified electing fund election can pass long-term capital gains through to such shareholder. Under the proposed regulations, a PFIC with respect to which the applicable shareholder has a QEF election is not treated as a corporation for purposes of Section 1061. Therefore, a partnership interest held by a PFIC with respect to which the applicable shareholder has a QEF election in effect may be an API if the interest otherwise qualifies as an API.
Observation(s): REITs and RICs are also entities that are treated as corporations for U.S. federal income tax purposes that generally pass long-term capital gains through to shareholders. Under the proposed regulations, partnership interests held by a REIT or RIC continue to be excluded from Section 1061.
LOOK-THROUGH FOR REIT AND RIC CAPITAL GAIN DIVIDENDS
Practitioners had questioned whether and to what extent Section 1061 applied to REIT and RIC capital gain dividends received by a partnership and allocated to a holder of an API. The proposed regulations helpfully provide for a look-through rule. In general, long-term capital gain treatment is available to the extent that the 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, including Section 1231 gains. However, REITs and RICs are required to report the necessary information to allow its shareholders to benefit from this look-through rule and accurately calculate their tax liability.
Observation(s): This look-through rule is welcome news for investors in REITs and clarifies that there is no need to restructure carry arrangements “below the REIT” in order to avoid being subject to Section 1061 on Section 1231 gains of the REIT (although other tax savings may continue to warrant such structure).
DIVIDED HOLDING PERIODS
Section 1061 raised questions about how a taxpayer would determine its holding period in APIs, particularly when a taxpayer is granted multiple APIs or also holds a capital interest in the issuing partnership. Under general tax principles, a partner is considered to have a unitary interest in a partnership regardless of whether multiple interests have been issued over time or if that interest is represented by different classes of interests. However, in such cases the holder can have a “split” holding period in its unitary partnership interest based on when each portion of such interest was acquired and the relative values of each such portion at the time of its acquisition. This general rule created uncertainty regarding how to value of APIs and other profits interests at the time of their acquisition for purposes of calculating the holder's split holding period. The proposed regulations attempt to resolve this issue by requiring holders to calculate split holding periods by reference to the value of a profits interest (whether or not an API) at the time of disposition, rather than at the time such profits interest was acquired.
Observation(s): The proposed regulations may provide for unexpected results for taxpayers whose partnership interests are comprised of a capital interest and/or one or more profits interests (including APIs), particularly if issued at different times.
TRANSFERS TO RELATED PARTIES
If a taxpayer transfers an API to certain “related persons,” Section 1061 can trigger the recognition of short-term capital gain even in the case of a transfer that otherwise would not be a taxable event. For this purpose, “related person” means certain members of the taxpayer’s family, any person who performed a service within the current or preceding three calendar years in the same ATB to which the transferred API relates, and any passthrough entity to the extent that a related person holds an interest in such passthrough entity. The proposed regulations clarify that a contribution to a partnership is not a “transfer” to a related person because the contributor does not escape the application of Section 1061 as a result of the operation of Section 704(c), which requires that the unrealized gains be allocated to the contributor when recognized. In addition, the proposed regulations generally do not treat transfers to entities that are disregarded as separate from their owners under any provision of the Code or the Treasury Regulations, including grantor trusts and qualified subchapter S subsidiaries, as transfers to related persons for purposes of Section 1061.
Observation(s): As drafted, the proposed regulations require recognition of short-term capital gains in many circumstances that previously would have resulted in deferral. In particular, careful consideration should be given to any reorganizations of carry vehicles or restructuring of incentive arrangements in light of this rule. The proposed regulations do not address the circumstances under which issuances and forfeitures of partnership interests may be treated as indirect transfers subject to these rules.
The proposed regulations will generally be effective for taxable years beginning after the final regulations are published. However, taxpayers generally are permitted to rely on the proposed regulations before that time so long as they follow them in their entirety and in a consistent manner.
Observation(s): Taxpayers should carefully consider the extent that they want to rely on the proposed regulations (in particular as a result of the uncertainty regarding the application of the capital interest exception.
1 All Section references are to the Code.