The Internal Revenue Service (IRS) and the US Treasury Department released proposed regulations (REG-107213-18) under Section 1061 on July 31 providing guidance to the holders of certain carried interests. These rules are of particular interest to sponsors of private investment funds.
A carried interest (also referred to as a profits interest, a promote, or a performance allocation) is a partnership interest that is received for services to (or for the benefit of) a partnership that entitles the holder to share in future profits but not in existing capital value. As a general rule, service providers, including individual management team members of private fund sponsors, that receive a carried interest in a partnership are not required to treat the receipt of the carried interest as an income event. This means that carried interest recipients do not recognize any compensation income upon the grant of a carried interest and instead are entitled to receive a distributive share of future profits (which could consist of capital gains) if the partnership is successful.
As part of the 2017 Tax Cuts and Jobs Act, Congress added new Section 1061 to limit some of the perceived tax benefits associated with carried interests received by private fund managers. Section 1061 left the general treatment of carried interests unchanged, but provided that a taxpayer (other than a corporation) receiving a carried interest that was an applicable partnership interest (API) would be required to use a three-year holding period instead of a one-year holding period for determining long-term capital gains with respect to the carried interest. As background, gain on the disposition of a capital asset held for more than one year is typically treated as long-term capital gain, which is taxed at reduced rates for non-corporate taxpayers.
Section 1061 indicates that an API is a carried interest received or held by a taxpayer in connection with the performance of substantial services in any applicable trade or business (ATB). An ATB is a trade or business involving: (A) raising or returning capital; and (B) either (i) investing in or disposing of “specified assets” or (ii) developing “specified assets.” Specified assets consist of securities, commodities, real estate held for rental or investment, cash or cash equivalents, or options, as well as derivatives related to any of these items or partnership interests to the extent of the partnership’s interest in any of these items.
While the goal of Section 1061 appears relatively straightforward, there is significant ambiguity in the statutory language. The proposed regulations represent an effort by the IRS and the Treasury Department to resolve some of that ambiguity.
IMPORTANT FEATURES OF THE PROPOSED REGULATIONS
While the proposed regulations are quite detailed and address many complicated aspects of the implementation of Section 1061, the following features will be of particular interest to the investment funds sector.
Relevant Capital Gain
Section 1061 applies to a taxpayer’s capital gain with respect to an API and effectively substitutes a three-year holding period for the standard one-year holding period in determining whether the gain is long-term capital gain. The use of the words “with respect to” has created some uncertainty about whether the statute applies to a taxpayer’s distributive share of gain from the sale of an asset by an underlying partnership, a taxpayer’s gain from a disposition of the API itself, or to both types of gain. The proposed regulations clarify that Section 1061 applies to both types of gain.
In addition, the proposed regulations state that the relevant gain will include gain resulting from the disposition of a capital asset distributed from a partnership with respect to an API. We note that the proposed regulations do not change the default rule of Section 735, which provides that a partner takes a carryover holding period in an asset distributed by a partnership. As a result, the distributed property rule is only relevant if the partnership distributes to a holder of the API (API Holder) a capital asset that it held for less than three years. Furthermore, satisfaction of the three-year holding period is determined at the time the partner disposes of the distributed property.
The proposed regulations clarify that the relevant capital gains do not include long-term capital gain determined under Sections 1231 and 1256, qualified dividend income described in Section 1(h)(11)(B), and any other capital gain that is characterized as long-term or short-term without regard to the holding period rules in Section 1222, such as capital gain characterized under the identified mixed straddle rules described in Section 1092(b). So, for example, if a carried interest recipient is allocated a share of an investment fund’s qualified dividend income, the recipient is able to benefit from the reduced tax rate applicable to qualified dividend income even if the investment fund has held the underlying corporate shares for less than a three-year period.
Treatment of S Corporations and PFICs with QEF Elections
Because the terms of Section 1061 explicitly exclude carried interests held by corporations, advisors quickly noted the possibility that a carried interest held by an S corporation might be outside the scope of Section 1061. In Notice 2018-18, the IRS indicated that it would issue regulations that explicitly limit the exception for corporations to C corporations. The notice also indicated that the regulations would be effective for taxable years beginning after December 31, 2017 (i.e., retroactive to the effective date of Section 1061).
The proposed regulations deliver on the promise of Notice 2018-18 and specifically exclude S corporations (as well as certain passive foreign investment companies with respect to which a “qualified electing fund election” has been made) from the exception for corporations. While the proposed regulations are generally intended to be applicable for dates following finalization, assuming these regulations are finalized in their current form, the specific rule for S corporations would be retroactively applicable for taxable years beginning after December 31, 2017.
Whether the statutory exclusion for corporations should cover an API held by an S corporation may be the subject of ongoing debate. However, the fact that this rule is being treated as an exercise of an explicit grant of regulatory authority makes it apparent that the IRS will adhere to the position announced in Notice 2018-18 (assuming these regulations are finalized in their current form).
Taxpayers Exempt from the Section 1061 Rules
In addition to restating various exemptions from treating a taxpayer as an API Holder, the proposed regulations add an additional exemption from such treatment. This exemption applies to a taxpayer who purchases an API from an API Holder on an arm’s length basis, provided that the taxpayer (1) has not and does not provide services to the relevant ATB and (2) is unrelated to any service provider to the relevant ATB. However, the proposed regulations do not exempt from API treatment tiered interests held by a taxpayer that has not and does not provide services to the relevant ATB as a result of capital contributions made through a tiered partnership structure.
The preamble to the proposed regulations also invites comments as to whether, under existing profits interest guidance, taxpayers that do not provide significant services should be entitled to profits interest treatment. These aspects will require careful consideration, particularly in the context of seeding or keystone investors in investment funds that may seek a sharing of carried interests.
Transfers to a Related Party
Section 1061(d) indicates that if a taxpayer transfers an API to a related person, the taxpayer will include in income (as short-term capital gain) the excess of: (A) so much of the taxpayer’s long-term capital gains with respect to the interest attributable to the sale or exchange of any asset held for not more than three years as is allocable to such interest, over (B) any amount treated as short-term capital gain under Section 1061(a) with respect to the transfer of the interest. Not surprisingly, there has been significant uncertainty regarding this provision. In particular, there has been a concern that this provision would trigger gain for transfers that would normally be nonrecognition events (e.g., gifts). The proposed regulations confirm that this provision will apply to treat a transfer of an API in an otherwise nontaxable transaction as a gain recognition event.
For purposes of this rule, the statute indicates that a related person is limited to: (1) a family member (as defined in Section 318(a)(1)); or (2) a person that performed services within the current calendar year or the preceding three calendar years in any ATB in which or for which the taxpayer performed a service. The proposed regulations clarify that the applicability of the second category is limited to a person that performed services in the “Relevant ATB” which is the ATB to which the taxpayer’s API relates. In addition, the proposed regulations indicate that a related person will include a passthrough entity in which an interest is held by a related person (e.g., a family member or colleague). However, a transfer of an API to a partnership that qualifies as a Section 721 contribution will generally not require current gain recognition under Section 1061(d), because the Section 704(c) rules would allocate built-in gain existing at the time of the transfer to the transferor. We note that the proposed regulations do not explicitly address the tax treatment of additional appreciation with regard to an API after it is contributed to a partnership.
The proposed regulations effectively adopt a mark-to-market regime for transfers to a related person that would otherwise qualify for nonrecognition. Essentially the transferor is required to recognize as short-term capital gain the gain that would be allocated to the transferor if immediately before the transfer the underlying partnership had sold all of its capital assets that it held for three years or less. Interestingly, the related party transfer rule does not appear to capture gain in the API itself, and so distinctions between a partner’s holding period in the API and the underlying partnership’s holding period in its capital assets may be relevant in this context.
As a final consideration, while the actual gain triggered under the related-party transfer rule may be minimal if an API is transferred soon after a grant, this does not necessarily eliminate the application of Section 1061 to the transferred interest. The API would still be considered an API in the hands of a related person. However, for purposes of the normal application of the Section 1061(a) rule, whether a person is “related” will depend on the rules of Sections 267 and 707. Because of differences in the definition of “family” in Sections 318(a) and 267(c)(4), there may still be some opportunity to use gifts to remove an API from the scope of Section 1061 (such as through an immediate gift of an API from a service provider to his or her sibling).
Holding Period Issues
A partner’s interest in a partnership is generally treated as a single asset with a unitary basis and a single holding period, even if the interest is divided into separate units or grants for state law purposes. Despite this general rule, Treasury Regulation Section 1.1223-3 acknowledges the possibility of a bifurcated holding period. For example, assume a partner acquires a partnership interest in Year One, and in Year Three (when the partnership interest is worth $100), the partner contributes an additional $50 to the partnership. In such a situation, Treasury Regulation Section 1.1223-3 indicates that following the Year Three contribution, the partner will have a bifurcated holding period, with 1/3 of the partnership interest being treated as newly acquired and 2/3 of the partnership interest being treated as having a long-term holding period. Because Treasury Regulation Section 1.1223-3 looks to the relative fair market value of portions of a partnership interest acquired at different times, without these proposed regulations it is not clear how (or even if) this regulation applies to a carried interest grant to an existing partner.
The proposed regulations, if finalized in their current form, would amend Treasury Regulation Section 1.1223-3 to provide that when an existing partner receives a carried interest (whether or not it is an API), the bifurcation analysis is performed immediately before a disposition event when the additional value associated with the carried interest becomes apparent. This modification to Treasury Regulation Section 1.1223-3 will not be applicable until after these proposed regulations are finalized.
The proposed regulations also confirm, consistent with existing rules, that in general the holding period applicable to the sale of a capital asset is determined at the level of the seller of that capital asset. Thus, for example, a partnership may have held a capital asset for more than three years, but an API Holder in that partnership may have held its interest in that partnership for less than three years. If the partnership sells the capital asset, the API rules will not apply to the gain allocated to the API Holder, but if the API Holder sells its interest in the partnership, the API rules will apply. Conversely, if the API Holder has held its interest for more than three years, but the partnership has held an asset for less than three years, the API rules can apply to the API Holder’s distributive share of gain if the partnership sells that asset.
Capital Interest Considerations
Section 1061(c)(4) provides that an API does not include a capital interest in the partnership that provides the taxpayer with a right to share in partnership capital commensurate with: (i) the amount of capital contributed; or (ii) the value of the interest subject to tax under Section 83 upon the receipt or vesting of such interest.
While the statutory language focuses on the actual amount contributed or the compensatory amount associated with the grant of a capital interest, the proposed regulations implement a more complicated test. Specifically, the proposed regulations acknowledge that a partner holding an API may nevertheless receive allocations that qualify for the exception in Section 1061(c)(4). These allocations are referred to as “Capital Interest Allocations.” An allocation is considered a Capital Interest Allocation if it is based on the partners’ respective capital account balances. The proposed regulations are not explicit on whether this also means, in the context of typical hedge funds, that a general partner’s share of later year profits reflecting an earlier year allocation of carried interest to the general partner’s capital account could be treated as a Capital Interest Allocation. The proposed regulations also do not specifically address whether catch-up or equalization allocations (including allocations related to revaluations or recapitalizations) might allow a holder of an API to treat subsequent allocations as a Capital Interest Allocation. As a practical matter, the manner in which many private funds handle their allocations may make it difficult for them to satisfy the test for Capital Interest Allocations set forth in the proposed regulations.
Carry Waiver Arrangements
The preamble to the proposed regulations notes that the Treasury Department and the IRS are aware of, and may challenge on various grounds (including anti-abuse and substance-over-form arguments), carry waiver arrangements whereby a taxpayer holding an API may seek to allocate gains generated from capital assets held for more than three years, or other gains eligible for capital gains treatment without the application of a holding period, to the taxpayer, in lieu of capital gains held for less than three years, by waiving its rights to be allocated the shorter period capital gains. The proposed regulations do not include specific provisions regarding these sorts of arrangements. We note that the Treasury Department and the IRS previously proposed, but have not finalized, proposed regulations and other guidance regarding management fee waiver arrangements.
- The IRS and the Treasury Department have worked for two-and-a-half years on these proposed regulations, and these proposed regulations have been through two rounds of review by the Office of Management and Budget. There may be a similar delay before these regulations are finalized. In general, these proposed regulations have a prospective effective date.
- Because Section 1231 gains are not considered relevant capital gains for purposes of Section 1061, holders of APIs in real estate funds or private equity funds that invest in operating partnerships may have a particular interest in how dispositions are structured. For example, a direct sale of real estate or operating business assets that generate Section 1231 gains would not be subject to recharacterization under Section 1061, but a sale of an interest in a partnership holding real estate or operating business assets could.
- The amendments to Treasury Regulation Section 1.1223-3 may appear straightforward when there is an additional profits interest grant to an existing partner. However, this amendment raises the concern that a simple change to a partnership’s allocation formula could have holding period implications for its partners.
- For purposes of identifying Capital Interest Allocations, the proposed regulations do not require capital accounts to be maintained under the Section 704(b) regulations – it is enough that a partnership maintains accounts using principles similar to those provided by the Section 704(b) regulations. The preamble to the proposed regulations also requests comments on other allocation arrangements that appropriately could be treated as Capital Interest Gains and Losses (i.e., long-term capital gains and losses with respect to an API Holder’s capital investment in a passthrough entity), which presumably reflect a recognition that most private equity funds follow a distribution-driven model, and most hedge funds follow a realized and unrealized gains and losses model, rather than the allocation approaches provided for under the Section 704(b) regulations.
- The proposed regulations greatly expand the statute and involve a surprising amount of complexity. The IRS and Treasury Department appear to acknowledge this and have requested comments about whether a simplified regime might be more appropriate for smaller partnerships.