The U.S. Department of the Treasury (“Treasury”) and the U.S. Internal Revenue Service (the “IRS”) on July 31, 2020 issued long-awaited proposed regulations (the “Proposed Regulations”) providing guidance under section 1061 of the U.S. Internal Revenue Code of 1986, as amended (the “Code”). Section 1061, which was added to the Code as part of the Tax Cuts and Job Act of 2017, addresses the tax treatment by recipients of “carried interests” and “performance allocations” with respect to taxable years beginning after 2017.
Alternative fund managers commonly receive two forms of revenue in exchange for services provided to a managed fund - a management fee based on a percentage of commitments or assets under management, and a performance-based return calculated as a percentage of the fund’s net profits. For funds that are treated as partnerships for US federal income tax purposes, the performance-based return generally is structured as a profits interest in the partnership. This profits interest commonly is referred to as a “performance allocation” (in respect of hedge funds and other funds investing primarily in marketable securities), or a “carried interest” (in respect of private equity funds and other funds investing primarily in illiquid assets). For convenience, the remainder of this discussion refers to both performance allocations and carried interests as “carried interests.” Because a carried interest is subject to the same risk of loss as a partnership interest received by a third-party investor in exchange for a capital contribution, the net profits allocated to a fund manager in respect of its carried interest are treated as a distributive share of partnership profits. Accordingly, the character of the profits earned by the partnership (for example, long-term capital gain, short-term capital gain or ordinary income), generally flows through to the fund manager in the same manner as for other holders of partnership interests. To the extent that the fund’s profits consist of long-term capital gains (in general, gains from the disposition of capital assets having a holding period of more than one year) or certain other categories of income that are taxable to non-corporate taxpayers at favorable long-term capital gain rates (for example, qualified dividend income and certain income from “section 1256 contracts” that are subject to a special mark-to-market regime), these favorable long-term capital gain rates apply to a non-corporate partner’s distributive share of such profits.
Note: A common misperception is that hedge fund managers enjoy long-term capital treatment on all carried interest profits. In fact, a classic hedge fund strategy is likely to generate primarily short-term capital gains and losses due to frequent trading to capture short-term market swings. In the absence of long-term capital gain, the manager would not receive the benefit of reduced long-term capital gain tax rates.
Impact of Code section 1061 and the Proposed Regulations
Section 1061 alters the tax treatment applicable to carried interest recipients by extending the long-term capital gain holding period to more than three years (as opposed to more than one year), for taxable years beginning after 2017. Thus, capital gains derived by a carry recipient from dispositions of assets having a holding period of more than one year, but not more than three years, are recharacterized as short-term capital gains. The legislation itself contains many gaps and interpretive challenges. The Proposed Regulations address a number of these open issues, in some instances making liberal use of Treasury’s regulatory authority. Certain key aspects and their practical implications for fund managers are summarized below.
Scope of Application
Section 1061 recharacterizes certain net long-term capital gains as short-term capital gains by extending the otherwise applicable long-term holding period from more than one year to more than three years. This recharacterization applies with respect to an “applicable partnership interest” (“API”), which generally refers to an interest in partnership profits that is held directly or indirectly by, or transferred to, a taxpayer in connection with the performance of substantial services by the taxpayer or a related person in an “applicable trade or business.” The Proposed Regulations presume that services provided in connection with the transfer of the partnership interest are substantial. An “applicable trade or business” is defined to include any activity conducted on a regular, continuous, and substantial basis which consists, in whole or in part, of raising or returning capital, and either (i) investing in (or disposing of) “specified assets” (or identifying specified assets for such investing or disposition), or (ii) developing specified assets. Specified assets generally include 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. Also included is an option or derivative contract on a partnership interest to the extent that the partnership interest represents an interest in other specified assets.
A taxpayer (such as an individual, trust or estate) may hold one or more APIs directly or indirectly through one or more passthrough entities (including a partnership, S corporation, or a passive foreign investment company (“PFIC”) with respect to which the shareholder has a qualified electing fund (“QEF”) election in effect under Code section 1295). The Proposed Regulations provide a mechanism for applying the recharacterization treatment of Code section 1061 through one or more tiers of passthrough entities, each of which is treated as an API holder under the Proposed Regulations. Complex netting rules applied at the level of the ultimate carry recipient take into account net long-term capital gains attributable to all APIs held by the carry recipient to calculate an overall “recharacterization amount” of net long-term capital gains that is taxable as short-term capital gain.
Note: A common example of a passthrough entity treated as an API holder would be a limited partnership established to act as a special limited partner that receives a carried interest on behalf of its partners, who typically include the fund’s individual portfolio managers.
The Proposed Regulations clarify that recharacterization does not apply to capital gain that is characterized as long-term without regard to the holding period rules of Code section 1222 (which generally require a holding period of more than one year for long-term capital gain or loss treatment). Accordingly, Code section 1061 does not alter the long-term capital gain treatment afforded to certain categories of income pursuant to Code sections 1231 (relating to certain real and depreciable property used in a trade or business and held for more than one year) and 1256 (relating to certain regulated futures and other derivative contracts that are marked to market), or qualified dividends described in Code section 1(h)(11)(B).
Note: The exclusion of Code section 1231 gain from recharacterization under Code section 1061 favorably resolves an open question of particular importance to real estate fund managers.
Note: The preamble to the Proposed Regulations (the “Preamble”) provides that the IRS and Treasury are aware of carry waiver arrangements designed to avoid recharacterization under Code section 1061 by waiving rights to allocation of gains from assets having a holding period of three years or less in favor of gains or other income that is not subject to recharacterization under Code section 1061. The Preamble warns that these and similar arrangements may not be respected and may be challenged. As in the case of management fee waivers, such statements alone may have a chilling effect on market practice. It is unclear just how much entrepreneurial risk is required to avoid a successful challenge. Arrangements that provide for sufficient risk of loss (for example, by ensuring that replacement gains and income are neither realized nor unrealized at the time of the waiver) may be economically unattractive (particularly for waivers made near the end of the fund’s term).
Determination of Holding Period
In determining which holding period to apply for purposes of Code section 1061, the Proposed Regulations look to the holding period of the owner of the asset that is disposed of. Thus, if a partnership disposes of an asset or an API, the partnership’s holding period controls. In general, the applicable holding period for a disposition of an API is the holding period of the API holder that disposed of the API. Under certain circumstances, however, a look-through rule may apply to recharacterize a taxpayer’s API disposition gains as short-term capital gain, even though the taxpayer held the API for more than three years.
Exceptions to Recharacterization Treatment
The Proposed Regulations provide that once a partnership interest is an API, it remains an API and never loses that character, unless one of the exceptions to the definition of an API applies. Exceptions to API status include:
(i) any interest in a partnership directly or indirectly held by a corporation (excluding an S corporation or a PFIC with respect to which the shareholder has a QEF election in effect):
(ii) certain capital interests (discussed more fully below):
(iii) a partnership interest held by a person who is employed by another entity that is not engaged in an applicable trade or business and provides services only to such other entity;
(iv) an API that is acquired by a bona fide purchaser who (A) does not provide services, (B) is unrelated to any service provider, and (C) acquired the interest for fair market value; and
(v) subject to the exercise of regulatory authority (currently reserved in the Proposed Regulations) that would allow for such an exception, gain attributable to any assets not held for portfolio investment on behalf of third party investors.
Note: Pursuant to Code section 1061, the corporate exception referred to in clause (i) above applies to any interest in a partnership directly or indirectly held by a “corporation.” Thus, as drafted, Code section 1061 provides no carve-out from the exception for S corporations or PFICs that are subject to a QEF election. In support of what many believe to be an attempt to legislate by regulation, Treasury and the IRS point to the general regulatory authority granted to them by Code section 1061, as well as legislative history that extends this authority to include anti-abuse guidance. The carve-out for PFICs that are subject to a QEF election generally would apply to taxable years beginning after the date the Proposed Regulations are published in the Federal Register, whereas the carve-out for S corporations would apply retroactively to taxable years beginning after December 31, 2017.
Note: The Proposed Regulations reserve on providing an exception (described in clause (v) above) that would address family offices.
The Proposed Regulations clarify that the determination of a taxpayer’s net long-term capital gain with respect to the taxpayer’s APIs held during the taxable year takes into account long-term capital gains and losses recognized with respect to each such API (“API Gains and Losses”), including (i) long-term capital gain or loss from a deemed or actual disposition of the API, (ii) the taxpayer’s distributive share of net long-term capital gain or loss from the partnership with respect to the API, and (iii) long-term capital gain or loss on the disposition of a capital asset distributed from the partnership with respect to an API, if the asset is held for more than one year but not more than three years at the time the distributee-partner disposes of the property (taking into account the partnership’s holding period with respect to the asset).
To avoid circumvention of Code section 1061, the Proposed Regulations introduce the concept of “Unrealized API Gains and Losses,” which include unrealized short-term and long-term capital gains and losses that would be allocated to the API holder with respect to its API if the partnership sold all of its assets at fair market value and the proceeds were distributed in a complete liquidation of the partnership on any relevant date. Such amounts include (i) capital gains and losses that would be allocated to an API pursuant to a revaluation of the partnership’s capital accounts and (ii) built-in gain or loss with respect to contributed property that would be allocated to an API holder with respect to an API if the property were sold immediately before the contribution for the amount that is included in the contributing API holder’s capital account in the lower-tier passthrough entity. Unrealized API Gains and Losses become API Gains and Losses at the time they are recognized if attributable to an asset or API held for more than one year on the date of its disposition, and retain their character as such when allocated through passthrough entities in a tiered structure.
Note: The treatment of unrealized gain or loss allocated in respect of an API as API Gain or Loss when such gain or loss is later recognized thwarts attempts to avoid recharacterization under Code section 1061 by contributing or redesignating unrealized carried interest amounts so as to characterize such amounts as a capital interest rather than an API.
Capital Interest Exception
Of particular interest to fund managers is the scope of the exception for certain capital interests. Code section 1061 excepts from recharacterization capital gains and losses with respect to a capital interest. It does so by providing that an API does not include a capital interest in a partnership that provides a right to share in partnership capital commensurate with (i) the amount of capital contributed (determined at the time of receipt of such partnership interest), or (ii) the value of such interest subject to tax under Code section 83 upon the receipt or vesting of such interest.
The Proposed Regulations expand on this exception to a considerable degree. Rather than focus on contributed capital, the Proposed Regulations look to capital account balances to distinguish a capital interest from an API. In general, an allocation of gains and losses with respect to a capital interest (referred to as “Capital Interest Gains and Losses”) must be made in proportion to the relative value of the API holder’s capital account (including unrealized gains and losses) in the partnership. More specifically, Capital Interest Gains and Losses include allocations of long-term capital gain and loss made under the partnership agreement (referred to as “Capital Interest Allocations”) only if:
(i) the partnership has non-service partners unrelated to the API partner (“Unrelated Non-Service Partners”):
(ii) such allocations are made to the API holder and the Unrelated Non-Service Partners based on their respective capital account balances; and
(iii) (1) the allocations are made to Unrelated Non-Service Partners with a significant aggregate capital account balance (which is deemed significant if equal to 5 percent or more of the aggregate capital account balance at the time the allocation); (2) the allocations are made in the same manner to the API holder and the Unrelated Non-Service Partners; and (3) the terms of the allocations to the API holder and the Unrelated Non-Service Partners are identified both in the partnership agreement and on the partnership’s books and records and the allocations are clearly separate and apart from allocations made with respect to the API.
Allocations will be treated as made in the same manner if they are based on the partners’ capital account balances and have the same terms, the same priority, the same type and level of risk, the same rate of return, the same rights to cash or property distributions during partnership operations and on liquidation. An allocation to an API holder will not fail to be treated as a Capital Interest Allocation solely because it is subordinated to amounts allocated to Unrelated Non-Service Partners or not reduced by the cost of services provided by the API holder or a related person.
Note: The Proposed Regulations reflect market practice in not requiring a carried interest recipient to bear management fees and similar charges. Presumably the carried interest recipient need not self charge any carried interest, although the Proposed Regulations should address this point more explicitly. More generally, the approach adopted by the Proposed Regulations suffers from an inability to capture common arrangements that, under general principles, should not jeopardize the treatment of an interest as a capital interest. Examples include use of sub-capital accounts (for example, to track indirect investment through feeder funds, separate assets (or asset pools) and separate capital contributions) and differing fee and carried interest arrangements among Unrelated Non-Service Partners (for example, based on committed capital).
For purposes of applying the capital interest exception, a capital account does not include the contribution of amounts directly or indirectly attributable to any loan or other advance made or guaranteed, directly or indirectly, by any other partner or the partnership (or any person related to any such other partner or the partnership); repayments on the loan are, however, included in the capital account balance as those amounts are paid.
To account for tiered arrangements, Capital Interest Gains and Losses also include long-term capital gain and loss allocations made by a passthrough entity that holds an API (referred to as “Passthrough Interest Capital Allocations”). If attributable to Capital Interest Allocations made directly or indirectly to the passthrough entity from a lower-tier entity with respect to its capital account balance in the lower-tier entity, such allocations must be made by the passthrough entity to each of its owners in the same manner based on each owner’s share of the capital account in such lower-tier entity. If comprised solely of long-term capital gains and losses derived from assets (other than an API) directly held by the passthrough entity, such allocations generally must be made in the same manner to each of the owners of the passthrough entity based on each owner’s relative investment in the assets held by the passthrough entity. An allocation will not fail to qualify to be a Passthrough Interest Capital Allocation if the passthrough entity is a partnership and allocations made to one or more Unrelated Non-Service Partners have more beneficial terms than allocations to the API holders if the allocations to the API Holders are made in the same manner.
Capital Interest Gains and Losses also include long-term capital gain and loss recognized on the sale or disposition of all or a portion of an interest in a passthrough entity to the extent treated as a capital interest. The Proposed Regulations provide a method for distinguishing between Capital Interest Gains and Losses and API Gains and Losses upon disposition of an interest that includes both a capital interest and an API.
Note: Although not explicitly confirmed in the Preamble or the Proposed Regulations, the Proposed Regulations appear to allow recognized API gains that are retained in a partnership to be treated as a capital interest in a subsequent taxable year if allocations made with respect to such retained gains satisfy the conditions otherwise applicable to Capital Interest Gains and Losses, as described above. Such treatment avoids unnecessary distributions and recontributions of recognized API gains that otherwise might be required to satisfy a literal interpretation of the capital interest exception as described in Code section 1061, which refers to allocations made with respect to “contributed capital.” This broader interpretation is of particular benefit to hedge fund managers that receive performance allocations. Such allocations are credited to the recipient’s capital account and, if not distributed, generally are allocated a pro rata share of partnership profits and losses in subsequent partnership taxable years.
Note: While the Proposed Regulations clarify and expand on the capital interest exception, the detailed requirements may in fact exclude certain interests that, under general partnership principles, would be considered capital interests, as previously noted.
The Proposed Regulations provide a transition rule for partnership property that was held by a partnership for more than three years as of the effective date of section 1061. Specifically, 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, as “Partnership Transition Amounts.” Partnership Transition Amounts that are allocated to an API holder are not taken into account or otherwise subject to recharacterization under section 1061.
For amounts to be treated as Partnership Transition Amounts, a partnership must make a signed and dated election by the due date, including extensions, of its partnership return for the first partnership taxable year in which it treats amounts as Partnership Transition Amounts. By this same due date, the partnership must also clearly and specifically identify all of the assets held by the partnership for more than three years as of January 1, 2018, in the partnership’s books and records. The election applies to the year for which the election is made and all subsequent years. Taxpayers may rely on the Proposed Regulations to make the election for taxable years beginning in 2020 or in a later year before the final regulations apply.
Special Rules Applicable to Capital Gain Dividends of REITs and RICs
The Proposed Regulations provide special rules for real estate investments trusts (“REITs”) and regulated investment companies (“RICs”). REITs and RICs may report dividends attributable to net capital gains derived by such entities as “capital gain dividends.” Such dividends are treated by shareholders as gain from the sale or exchange of a capital asset held for more than one year. The Proposed Regulations provide for more detailed reporting that should allow for long-term capital gain treatment under Code section 1061 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. Specifically, a RIC or a REIT that reports or designates all or a part of a dividend as a capital gain dividend may disclose two additional amounts based on a modified computation of its net capital gain. A RIC or REIT may disclose a modified capital gain dividend amount that excludes from the computation amounts not taken into account for purposes of Code section 1061. Alternatively, a RIC or REIT may disclose both (i) a modified capital gain dividend amount that excludes from the computation amounts not taken into account for purposes of Code section 1061 and (ii) a modified capital gain dividend that applies a holding period of more than three years in lieu of a holding period of more than one year in applying Code section 1222. The amount reported under clause (i) is used to calculate API gain attributable to holding periods of more than one year, whereas the amount reported under clause (ii) is used to calculate API gain attributable to holding periods of more than three years. If however, the amount described in clause (i) is not disclosed, the full amount of the RIC’s or REIT’s capital gain dividend must be used to calculate API gain attributable to holding periods of more than one year. If the amount described in clause (ii) is not disclosed, no amount of the RIC’s or REIT’s capital gain dividend may be used to calculate API gain attributable to a holding period of more than three years. Each of the two additional disclosed amounts provided to each shareholder of a RIC or REIT must be proportionate to the share of capital gain dividends reported or designated to that shareholder for the taxable year. In addition, any loss on the sale or exchange of REIT or RIC shares held for less than six months will be treated as capital loss on assets held for more than three years to the extent of any disclosed amounts described in clause (ii) that were included in the calculation of an API gain attributable to holding periods of more than three years.
Transfers of APIs to Related Parties
If a taxpayer transfers an API to a related person (as defined for this purpose in Code section 1061), the taxpayer must recognize, as short-term capital gain, the excess of (i) the net built-in long-term capital gain in assets attributable to the transferred interest with a holding period of three years or less, over (ii) the amount of recognized long-term capital gain that is treated as short-term capital gain under Code section 1061. This gain recognition requirement applies regardless of whether the transfer is otherwise a taxable event. The Proposed Regulations refer to contributions, distributions, sales, exchanges and gifts as examples of transfers that may trigger gain recognition. For this purpose, a related person includes a family member, certain colleagues who provided services in the applicable trade or business to which the API relates, and a passthrough entity to the extent owned directly or indirectly by any such family members or colleagues.
The Proposed Regulations impose reporting obligations on both carried interest recipients and passthrough entities to evidence taxpayer compliance with Code section 1061 and allow for proper determinations of recharacterization amounts. Penalties will apply to a passthrough entity that fails to comply with its reporting obligations.
The Proposed Regulations generally would apply to taxable years of carried interest recipients and passthrough entities beginning on or after the date that final regulations are published in the Federal Register. Taxpayers may, however, rely on the rules relating to transition relief for taxable years beginning in 2020 and subsequent taxable years beginning before the date final regulations are published (without following all of the provisions of the Proposed Regulations) if the relevant partnership treats capital gains and losses from the identified assets as transition amounts for the year in which the election is made and all subsequent taxable years beginning before the date final regulations are published. Carried interest recipients and passthrough entities may rely on the remaining provisions of the Proposed Regulations for taxable years beginning before the date that final regulations are published if they follow such provisions in their entirety and in a consistent manner. In addition, as noted above, the exclusion of S corporations from the exception for corporations would apply retroactively to taxable years beginning after 2017.
Prior to the enactment of the Tax Cuts and Jobs Act of 2017, numerous legislative proposals attempted to revise the tax treatment of carried interest so as to eliminate what some members of Congress perceived as an unwarranted benefit to carried interest recipients. Such proposals generally would have subjected all or a portion of the income derived from such interests to taxation at ordinary income tax rates. By contrast, Code section 1061 took what many consider to be a more measured approach, by recharacterizing otherwise long-term capital gains derived from a carried interest as short-term capital gain only to the extent that such gains are characterized by reference to the holding period rules of Code section 1222 and the applicable holding period does not exceed three years. Implementation of this more measured approach, as contemplated by the Proposed Regulations, would, however, lead to heightened complexity and administrative burden.