On July 31, 2020, the U.S. Internal Revenue Service (the "IRS") and the U.S. Treasury Department ("Treasury") issued proposed regulations (the "Proposed Regulations") that provide taxpayers with definitional and computational guidance regarding how to interpret the carried interest rules (the "Carried Interest Rules") under Section 1061 of the Internal Revenue Code of 1986, as amended (the "Code").1
The Carried Interest Rules, enacted by Pub. L. No. 115-97 (commonly known as the Tax Cuts and Jobs Act), generally impose a new three-year holding period requirement in order for gains arising with respect to a "carried interest" in an applicable partnership interest (an "API") to qualify as long-term capital gain. Pursuant to the Carried Interest Rules, an API generally is an interest in a partnership transferred to or held by the taxpayer in connection with the performance of "substantial services" by the taxpayer, or any other related person, in any "applicable trade or business" (an "Applicable Business"), which generally encompasses a range of financial services activities.
Summary of Key Points
The important highlights of the Proposed Regulations are that they:
- Clarify that, with respect to an API held by a passthrough entity, the "taxpayer" subject to the Carried Interest Rules is determined based on the "partial entity" approach, which generally means that whether or not there is an API subject to these rules is determined by looking at the passthrough entity owner, but the amount of long-term capital gain recharacterized as short-term capital gain is determined at the beneficial owner level.
- Provide certain exceptions to the Carried Interest Rules such as an exception providing that an unrelated purchaser of an API that is not itself providing relevant services is not required to treat the acquired interest as an API¨
- Provide rules for calculating the amount of gains subject to recharacterization as short-term gains, including guidance for applying such rules through tiers of flow-through entities; at which level to apply the three-year holding period requirement; and exceptions to recharacterization¨
- Provide a look-through rule that generally recharacterizes long-term capital gain arising from the sale to an unrelated person of an API held for more than three years as short-term gain if 80 percent or more of the assets of the partnership have a holding period of three years or less at the time of disposition¨
- Generally are effective for tax years beginning on or after the date final regulations are issued—but taxpayers can rely on the Proposed Regulations prior to finalization, provided they follow these rules in their entirety and in a consistent manner. Certain rules applicable to S corporations, however, are effective for tax years beginning after December 31, 2017.
Taxpayers Subject to the Carried Interest Rules
The Proposed Regulations adopt the so-called "partial entity" approach to determine what taxpayers are subject to these rules. This means that whether or not there is an API subject to these rules is determined by looking at the entity, but the amount of long-term capital gain recharacterized as short-term capital gain, which the Proposed Regulations refer to as the "Recharacterization Amount," is determined at the owner level. To apply this approach, the Proposed Regulations provide for two definitions of a "taxpayer": (1) the "Owner Taxpayer," which is the taxpayer actually paying taxes on the net gains from an API and (2) the "Passthrough Taxpayer," which generally is an entity that does not itself pay taxes.
Under the Proposed Regulations, the Recharacterization Amount is determined solely by the Owner Taxpayer. Thus, if an Owner Taxpayer holds one or more APIs indirectly, amounts subject to the Carried Interest Rules flow through the applicable entities and are calculated at the Owner Taxpayer level. A Passthrough Taxpayer can be (i) the service provider, (ii) a person related to the service provider, (iii) a person engaged in an Applicable Business, or (iv) the recipient of an interest in connection with the performance of substantial services in an Applicable Business. An Owner Taxpayer and a Passthrough Taxpayer each are treated as a taxpayer for the purpose of determining whether an API exists.
If a Passthrough Taxpayer is treated as the recipient (or holder) of a partnership interest, directly or indirectly, for purposes of determining the existence of an API, the ultimate owners of the Passthrough Taxpayer generally are treated as Owner Taxpayers for the purpose of determining the Recharacterization Amount (excluding owners excepted from the application of the Carried Interest Rules).
Partnership Interests Subject to the Carried Interest Rules
The Carried Interest Rules and Proposed Regulations define an API as any interest in a partnership which, directly or indirectly, is transferred to (or held by) an Owner Taxpayer or Passthrough Taxpayer in connection with the performance of substantial services by such taxpayer, or by any other related person, in any Applicable Business.
Importantly, the Proposed Regulations provide that once a partnership interest becomes an API, the partnership interest remains an API unless and until an exception applies, regardless of whether the relevant taxpayer or a related person continues to provide services in the relevant Applicable Business. Thus, unless an exception applies, once a partnership interest is an API it will remain an API regardless of whether services continue to be provided or whether an Owner Taxpayer retires.
The Proposed Regulations also clarify that for purposes of the Carried Interest Rules an interest in a partnership includes any financial instrument or contract, the value of which is determined, in whole or in part, by reference to the partnership (including the amount of partnership distributions, the value of partnership assets, or the results of partnership operations). Further, the Proposed Regulations provide the broad presumption that if an Owner Taxpayer, Passthrough Taxpayer or related person provides any services in an Applicable Business and an allocation of a partnership's profits is transferred to or held by such person in connection with those services, those services are considered "substantial" for purposes of the Carried Interest Rules.
The Proposed Regulations also clarify that an Owner Taxpayer that holds an indirect interest in the partnership that originally issued an API through one or more tiers of passthrough entities is considered to be an API holder. In this case, each passthrough entity in a tiered structure is also treated as an API holder, although the Recharacterization Amount is only calculated by the Owner Taxpayer. A passthrough entity for these purposes includes a partnership, S corporation or a passive foreign investment company (a "PFIC") with respect to which the shareholder has a qualified electing fund ("QEF") election in effect under Section 1295.
Partnership Interests Excluded from the Carried Interest Rules
The Carried Interest Rules include four exceptions to the definition of API. The Proposed Regulations generally add an additional exception and otherwise clarify the existing exceptions.
- Bona Fide Unrelated Purchaser Exception: The Proposed Regulations add an exception for unrelated taxpayers who purchase an API. This rule generally provides that an interest in a partnership that would be treated as an API but is purchased by an unrelated buyer for the fair market value of the interest is not an API with respect to the buyer if: (1) the buyer does not currently and has never provided services in the relevant Applicable Business (or to the passthrough entity in which the interest is held, if different), and does not contemplate providing such services in the future, and (2) is not related to a person who provides services either (x) in the relevant Applicable Business or (y) to or for the benefit of the partnership (or a lower-tier partnership in which the partnership directly or indirectly holds an interest).
- Corporate Exception: The Carried Interest Rules provide that an API does not include a partnership interest directly or indirectly held by a corporation. Consistent with prior IRS guidance, the Proposed Regulations provide that partnership interests held by S corporations are treated as APIs if the interest otherwise meets the API definition. This clarification is intended to prevent potential planning with S corporations that would have otherwise avoided the application of the Carried Interest Rules. The Proposed Regulations also clarify that a PFIC with respect to which the shareholder has a "QEF" election in effect is not treated as a corporation for these purposes.
Observation: The Proposed Regulations (and prior guidance in the case of S corporations) require taxpayers that implemented structures involving S corporations or certain PFICs to sidestep the Carried Interest Rules to consider alternative arrangements as the IRS's position is that certain corporations do not fall within the exception intended by Congress despite the plain language of Section 1061(c)(4)(A). Treasury's position is that the Proposed Regulations excluding S corporations and certain PFICs from this exception for corporations are necessary and appropriate to avoid allowing a drafting oversight to undermine the purposes of the Carried Interest Rules and that the grant of regulatory authority in Section 1061(f) is sufficient to overcome the plain language of the statute.
- Non-Applicable Business Employee Exception: The Carried Interest Rules and Proposed Regulations provide that an API does not include a partnership interest held by a person who is employed by another entity that is conducting a trade or business (other than an Applicable Business) and provides services only to such other entity.
- Capital Interest Exception: The Carried Interest Rules generally provide that an API does not include certain capital interests in a partnership. The Proposed Regulations implement the capital interest exception by excepting from recharacterization under the Carried Interest Rules long-term capital gains and losses that represent a return on an API holder's invested capital in a passthrough. The Proposed Regulations provide a set of technical rules for determining if capital gains and losses allocated to an API holder are treated as allocations with respect to its capital investment. In general, an allocation must be made in proportion to the relative value of the API holder's capital account (including unrealized gains and losses) in the passthrough entity in order to be an allocation with respect to a capital investment.
Observation: Many transactions involving partnerships and limited liability companies have complex distribution waterfalls that reflect the manner in which the parties have decided to share the economics of the deal. A safe harbor from the Carried Interest Rules for invested capital based on pro rata allocations is too simplistic and does not appreciate the many ways in which transactions are structured to achieve bona fide non-tax business objectives. Treasury's concern that any safe harbor other than one based on pro rata capital accounts will lead to unintended tax avoidance has rendered the safe harbor ineffective in providing taxpayers additional guidance on the scope of the Carried Interest Rules. In other words, even without this narrow safe harbor, a taxpayer would have been able to establish that the interest received for invested capital that is only entitled to pro rata allocations was not an interest in a partnership transferred to or held by the taxpayer in connection with the performance of "substantial services" by the taxpayer.
- Section 1061(b) Exception: Section 1061(b) generally excludes from recharacterization income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors. The Proposed Regulations, however, reserve with respect to the application of Section 1061(b).
Businesses Subject to the Carried Interest Rules
A partnership interest is not subject to the Carried Interest Rules unless it is held or transferred in connection with the performance of substantial services by the taxpayer or a related person in an Applicable Business.
An Applicable Business generally is defined as any activity conducted on a regular, continuous and substantial basis that consists, in whole or in part, of raising or returning capital and investing in (or disposing of) or developing specified assets. For purposes of the Carried Interest Rules, an activity is conducted on a regular, continuous and substantial basis if the total level of activity (conducted in one or more entities) by the taxpayer and certain related parties satisfies the level of activity required to establish a trade or business for purposes of Section 162. While the General Partner or other carried interest recipient may not generally be engaged in a trade or business for purposes of Section 162, the fund manager generally will, and the General Partner or other carried interest recipient will generally be attributed the manager's trade or business under the related party or delegate rules in the Proposed Regulations.
Specified assets generally include securities (including partnership interests that are publicly traded or widely held), commodities, real estate held for rental or investment, cash or cash equivalents, partnership interests to the extent the partnership holds other specified assets, and options or derivative contracts with respect to other specified assets.
The Proposed Regulations provide that it is not necessary for both raising or returning capital actions and investing or developing actions to occur in a single year for an Applicable Business to exist in that year. For example, an Applicable Business can exist in a taxable year where there is sufficient raising or returning of capital in anticipation of future investing or developing actions or where there is investing or developing actions with respect to a prior year's raising or returning of capital. Conversely, an interest in a partnership may be issued to a service provider in anticipation of the service provider providing services to an Applicable Business but will not be considered an API if the Applicable Business does not exist at the time of transfer. Once the interest becomes an API, its status as an API does not depend on whether the Applicable Business continues to meet the Section 162 standard.
Computing the Recharacterization Amount
The Proposed Regulations provide detailed rules for computing an Owner Taxpayer's Recharacterization Amount, including rules governing such computation when an API is held through one or more tiers of passthrough entities. In general, an Owner Taxpayer's Recharacterization Amount is equal to (1) the Owner Taxpayer's net long-term capital gain amount computed based on the general one-year holding period, less (2) the Owner Taxpayer's net long-term capital gain amount computed based on the three-year holding period, with the difference representing amounts which cleared the one-year hurdle but not the three-year hurdle. As discussed above, if an Owner Taxpayer holds one or more APIs indirectly, amounts subject to the Carried Interest Rules flow through the applicable entities and are calculated at the Owner Taxpayer level. The Recharacterization Amount applies to an Owner Taxpayer's distributive share of income from an API, gain on dispositions of an API, and gain on dispositions of assets distributed with respect to an API. With respect to gain on sales of an API, if such API has been held for more than three years, a special look-through rule applies if 80 percent or more, by fair market value, of the partnership's assets have been held by the partnership for three years or less. The look-through rule is discussed in more detail below. Application of the Carried Interest Rules both to gain on sales of APIs and assets distributed with respect to an API closes two potential workarounds to the Carried Interest Rules contemplated by practitioners (i.e., selling partnership interests, on the one hand, and causing the partnership to make in-kind distributions, on the other).
Determining the applicable holding periods is critical to the calculation of the Recharacterization Amount and was a source of confusion prior to the issuance of the Proposed Regulations. Taxpayers were left to wonder whether the applicable holding period was (1) the holding period of the asset sold, (2) the Owner Taxpayer's holding period in the API, (3) the partnership's holding period in the underlying assets, or (4) the lesser of options (2) and (3). The Proposed Regulations provide that the relevant holding period is the direct owner's holding period in the asset sold. As such, if the Carried Interest Rules apply to an Owner Taxpayer's distributive share of gain from a sale by the partnership of the underlying assets, then the partnership's holding period of such assets is determinative. If, on the other hand, an Owner Taxpayer sells an API or assets distributed with respect to an API, then the Owner Taxpayer's holding period is determinative (subject to the look-through rule for sales of an API). The Owner Taxpayer will have a tacked holding period in any assets distributed with respect to an API such that it includes both the Owner Taxpayer's holding period of such assets as well as the partnership's holding period prior to the distribution.
The Proposed Regulations also provide that gain that is classified as long-term or short-term under provisions other than the Section 1222 holding period rules generally are not subject to the Carried Interest Rules, including (i) Section 1231 gain (depreciable and real property used in a trade or business), (ii) Section 1256 ("mark-to-market" contracts), (iii) Section 1092 (mixed straddle rules), and (iv) qualified dividends.
Transfers of APIs
Look-Through Rule on the Sale of APIs to Unrelated Persons
The Proposed Regulations provide generally that gain or loss on the sale of an API will be considered to be gain or loss from the sale of a capital asset that is subject to the normal rules of Sections 741 and 751 (taking into account the three-year holding period rules discussed above). Therefore, except to the extent that a limited "look-through" rule applies (discussed below) or to the extent that Section 1061(d) applies (discussed below), the Proposed Regulations do not recharacterize such gain or loss based on the assets of the underlying partnership on the sale of an API to an unrelated person. In the case of certain sales of an API with a holding period of more than three years, however, the Proposed Regulations provide that gain otherwise constituting long-term capital gain to the holder may be recharacterized as short-term gain if 80 percent or more of the fair market value of the assets of the underlying partnership (i) would generate long-term capital gain on disposition that is not otherwise excluded from Section 1061 and (ii) have a holding period of three years or less to such partnership at the time of such sale. Special "look-through" rules also apply to tiered partnership arrangements and, importantly, these "look-through" rules do not apply to transfers to related persons that are governed by Section 1061(d) (discussed below).
Transfers of APIs to Related Persons
Under Section 1061(d), if a taxpayer transfers an API to a "related person," the taxpayer generally must include some amount of short-term capital gain in gross income. This rule applies whether or not the transfer is otherwise intended to be taxable or tax-free (in whole or part) under other provisions of the Code. Moreover, "transfer" is defined to include transfers by contribution, distribution, sale, exchange or gift, but does not presently include contributions to a partnership to the extent governed by Section 721 (and related Section 704(c) principles). Notably, the Proposed Regulations indicate that the treatment of Section 721 transfers is an area in which further comments are requested.
If a transfer of an API to a related person is taxable (without regard to Section 1061(d)), then all or a portion of the recognized gain to the taxpayer may be recharacterized as short-term capital gain. If a transfer of an API is, in whole or in part, non-taxable (without regard to Section 1061(d)), then the taxpayer nevertheless must include in gross income short-term capital gain equal to the difference between (i) the amount of built-in long-term capital gain in the assets of the underlying partnership that have a holding period of three years or less at the time of such transfer attributable to the transferred API, and (ii) any amount treated as short-term capital gain under Section 1061 with respect to the transferred API. This rule effectively accelerates tax in connection with a transaction that otherwise would not have required recognition of gain if the gain is described in clause (i) above and if the transfer of the API is to a related person. If the transferor of the API recognizes additional gain under these rules, then the transferee generally receives a basis increase in the transferred API to reflect such gain recognition.
For purposes of Section 1061(d), "related person" includes (i) a member of the taxpayer's family (within the meaning of Section 318(a)(1)), (ii) a person who performed a service within the current calendar year or the preceding three calendar years in any Applicable Business in which or for which the taxpayer performed a service or (iii) any passthrough entities owned directly or indirectly by such person (or persons).
Section 1.704-3(e)(3)(i) of the Treasury Regulations provides that, for purposes of making reverse Section 704(c) allocations, a securities partnership (generally, a management company or investment partnership) may aggregate gains and losses from certain financial assets using any reasonable approach that is consistent with the purpose of Section 704(c). The Proposed Regulations amend Section 1.704-3(e)(3) of the Treasury Regulations to provide that an approach will not be considered reasonable if it fails to take into account the application of the Carried Interest Rules. In this respect, the Proposed Regulations generally require that the partnership establish separate book and tax accounts for holders of an API that distinguish between capital interest gains and losses and other gains and losses.
The Proposed Regulations further indicate that the treatment of securities partnerships using the aggregation rules of Section 1.704-3(e)(3)(i) of the Treasury Regulations is another area in which further comments are requested.
The Proposed Regulations introduce additional reporting requirements on API owners and partnerships that are subject to the Carried Interest Rules. These reporting requirements generally require an Owner Taxpayer to report any information the IRS may require in forms, instructions or other guidance, sufficient for the IRS to determine whether the taxpayer has complied with the Carried Interest Rules and the Proposed Regulations. Additionally, a partnership (and other passthrough entities in tiered structures) that issue an API must (i) similarly report any information the IRS may require to determine compliance with the Carried Interest Rules and (ii) request and furnish information needed by the Owner Taxpayer to determine its Recharacterization Amount. The Proposed Regulations suggest that penalties could apply to partnerships that fail to comply with its reporting obligations and further provide for a number of unfavorable default treatments for the amount of an API holder's allocable share of certain items, unless such API holder is able to otherwise substantiate another amount.
A Note of Caution
Treasury notes in the preamble to the Proposed Regulations that it is aware that taxpayers may seek to circumvent the Carried Interest Rules by waiving their rights to gains generated from capital assets held for three years or less and substituting for these amounts gains generated from capital assets held for more than three years and similar arrangements. While not weighing in on the merits, there is a word of caution that the Code and Treasury Regulations and/or the substance over form and economic substance doctrines may disallow the tax consequences intended by taxpayers implementing these arrangements. The IRS has in the past compared such carry deferral arrangements to management fee waivers (whereby management fees are converted into profits interests), which are addressed in detail in another set of proposed regulations. Taxpayers implementing carry deferral mechanisms should take heed of such proposed regulations relating to management fee waivers, which generally provide that, in order to be respected, the sponsor must assume significant entrepreneurial risk in connection with such waiver (i.e., there must be a degree of uncertainty as to whether the sponsor will ultimately be made whole).
The Proposed Regulations provide useful guidance on the Carried Interest Rules and significantly impact structures used by taxpayers to provide incentives to sponsors in private equity and related industries. The rules leave unanswered, however, a number of questions that may be traps for the unwary or provide opportunities for planning in the appropriate circumstances.
1 Unless otherwise noted, “Section” references are references to sections of the Code.