Introduction and Background
Treasury and the IRS issued proposed regulations on July 31, 2020 under Section 1061 of the Code (Proposed Regulations). Section 1061 effectively creates a three-year holding period requirement in order to achieve favorable tax treatment for carried interests issued by funds and other investment partnerships. Before the enactment of Section 1061 by the Tax Cuts and Jobs Act of 2017, the holding period required for favorable long-term capital gains rates of carried interest holders was over one year. If the three-year holding period is not met, then a carried interest holder’s capital gain is taxed as short-term capital gain (which is generally taxed at ordinary income rates) rather than at long-term capital gain rates.
Welcome clarifications in the Proposed Regulations confirm that Section 1061 applies to recharacterize only gains from the sale of capital assets, and not gains that are simply afforded taxation as long-term capital gains under other provisions of the Code. For example, machinery and other assets used in a trade or business do not produce capital gains, but they are generally accorded the same tax treatment as capital gains. In addition, the Proposed Regulations clarify that the relevant holding period is that directly in the asset that is sold (whether that asset is a portfolio company sold by a fund or a carried interest sold by a manager). The Proposed Regulations contain a number of provisions aimed at preventing circumvention of Section 1061.
Overview of Section 1061
Section 1061 applies to individuals, trusts and estates that hold, directly or indirectly, a partnership interest (Carried Interest) that is transferred or held in connection with the performance of services to a trade or business conducted on a regular, continuous and substantial basis that consists in whole or in part of the following (Investment Business):
(i) raising or returning capital, and
(ii) investing or developing “specified assets” - generally including securities, commodities, real estate held for rental or investment, cash or cash equivalents, derivative contracts with respect to the foregoing assets, and interests in partnerships that own the foregoing assets.
While Section 1061 applies to interests owned by funds and investment partnerships, it generally does not apply to profits interests that are issued by operating businesses not engaged in investment activity.
The amount that a taxpayer is required to treat as short-term capital gain is the excess of the taxpayer’s (i) net long-term capital gains attributable to a Carried Interest applying a one-year holding period over (ii) net capital gains attributable to a Carried Interest applying a three-year holding period. This, a taxpayer that holds multiple Carried Interests may net gains and loss from them.
Gains to Which Section 1061 Does Not Apply
Excluded gains are not subject to the three-year holding period of Section 1061.
Certain Gain Excluded
The categories of excluded income limit Section 1061’s application narrower than some initially expected. While Section 1061 applies to all gain from the sale of a capital asset, the Proposed Regulations confirm that it does not apply to gain that is afforded the lower long-term capital gain rates under other provisions of the Code (and not from the sale of a capital asset). Under the Proposed Regulations, the following are excluded from the rules of section 1061:
-Section 1231 gain and losses. Section 1231 property includes real property and depreciable property used in a trade or business and held over one year. Examples include buildings, machinery, and land held over one year. This clarification is welcome news for the real estate investment industry. It is also positive confirmation for funds outside the real estate investment industry, because a substantial part of the gain on the sale of a portfolio company that is a flow-through entity (including gain attributable to goodwill) may be Section 1231 gain, and so escape the holding period requirement of Section 1061.
-Section 1256 gain and losses – Section 1256 contracts (generally including regulated futures contracts, foreign currency contracts, and nonequity options) that are held by a hedge fund at the end of each taxable year are treated for income tax purposes as if they were sold for their fair market value, and any gain or loss is treated as 60 percent long-term capital gain or loss and 40 percent short-term capital gain or loss, regardless of holding period. Thus, a significant portion of the income of many hedge funds is not subject to the three-year holding period of Section 1061.
-Section 1092(b) mixed straddle rules that characterize gain as capital gains also are outside the scope of Section 1061.
-Qualified dividend income (QDI) – QDI includes dividends from U.S. corporations and certain foreign corporations with respect to shares that meet a specified holding period.
Special Rules for RICs and REITs
Under the Proposed Regulations, to the extent a fund receives dividends from a regulated investment company (RIC) or a real estate investment trust (REIT) that is designated by the paying RIC or REIT as a capital gains dividend, such capital gains dividend will not be subject to recharacterization under Section 1061 if it is attributable to capital assets of the RIC or REIT that have been held for more than three years or to assets not subject to Section 1061.
RICs and REITs may (but are not required to) designate what portion of the capital gain dividend they pay is attributable to three-year property. If a RIC or REIT does not provide this information, the entire amount of the capital gain dividend paid is presumed to be attributable to one-year property. Funds investing in RICs or REITs may want to consider contractually obligating the RICs and REITs they invest in to provide them the relevant information.
Relevant Holding Period
The Proposed Regulations clear up confusion regarding which holding period is relevant when there is a discrepancy between the holding period of the holder in the Carried Interest, and the holding period of the fund in its assets. Under the Proposed Regulations, the relevant holding period is that of the direct owner in the asset that is being sold. This means:
If a fund sells a portfolio company, the fund’s holding period in the asset is the relevant holding period. For example, if a fund sells a portfolio company that it has held for more than three years, the portion of the gain allocated to a manager that has held a Carried Interest in the fund for less than three years will not be recharacterized under Section 1061.
If a holder of a Carried Interest sells the interest, the holder’s holding period in the Carried Interest is the relevant holding period. For example, if a carried interest holder sells the interest at a time she has held it for two years, the gain from the sale will be subject to recharacterization under Section 1061, even if the underlying assets of the fund have been held for more than three years.
Rules to ensure no easy circumvention of general holding period rule
The general rule – that the holder’s holding period in the Carried Interest is relevant only if the Carried Interest itself is being sold – is subject to two limited exceptions aimed at preventing sidestepping of the general holding period rule:
Exception 1: If 80 percent or more of the fair market value of all the assets of the fund that issued the Carried Interest have a holding period of three years or less, and the sale of such assets would produce long-term capital gain or loss, then the Proposed Regulations would recharacterize the percentage of the gain or loss on the disposition of the Carried Interest attributable to assets held three years or less. Stated a different way, if more than 20 percent of the underlying assets of the fund have been held for more than three years, this exception does not apply to recharacterize the gain.
For example, if a holder of a Carried Interest (which has been held for over three years) sells the interest at a time when 90 percent of the fund’s assets have been held for less than three years, then the look-through rule will apply, and 90 percent of the holder’s gain will be characterized as short-term capital gain.
Exception 2: If the service provider holds the Carried Interest through intermediate entities (for example, an S corporation), and any of the intermediate entities has a holding period in the underlying carried interest of three years or less, then all of the gain on the sale of the carried interest will be recharacterized.
For example, if a Carried Interest holder in an upper-tier partnership has held her Carried Interest for over three years, but the upper-tier partnership was issued a carried interest in an underlying fund within the last three years, then a sale of the Carried Interest by the holder will be recharacterized under Section 1061.
In-kind distributed property
The application of Section 1061 may not be avoided by having the fund distribute property to the Carried Interest holder instead of allocating gain to the Carried Interest holder on the sale of the property by the fund. The Proposed Regulations provide that if a partnership distributes property in kind to a holder of a Carried Interest, then gain from the sale of the distributed property will be subject to Section 1061 if the holding period of the property is not more than three years at the time of the sale (for this purpose, tacking the holding period of the partnership in the asset). While in-kind distributions cannot be used to sidestep Section 1061, they can be a helpful planning tool. The service provider recipient of an in-kind distribution can dispose of a distributed asset at his or her convenience, and individually determine whether the three-year holding period will be met.
For example, if a fund is disposing of stock that it has held for less than three years, the fund may distribute the Carried Interest holders’ pro rata portion of the stock directly to the Carried Interest holder rather than selling it. The Carried Interest holder would need to hold the stock until the three-year holding period is met to avoid recharacterization under Section 1061. If the Carried Interest holder decides to sell the stock before the three-year holding period is met, then the gain will be characterized as short-term capital gain under Section 1061.
Partnership Interests Excepted from Section 1061
The following partnership interests are excepted from Section 1061 and outside its reach:
Often, Carried Interest holders invest some capital alongside other investors. Section 1061 does not apply to gain attributable to a capital interest, which provides the taxpayer with a right to share in partnership capital commensurate with the amount of capital contributed or the value recognized by the taxpayer upon the receipt or vesting of the capital interest in the partnership. For example, a fund manager may invest capital equal to 1 percent of capital invested by all investors in the fund in exchange for a 1 percent capital interest she may also receive the right to receive a share of future appreciation in all assets of the fund that is disproportionately large to the capital interest (typically the carried interest provides the manager with a right to 20 percent of the future appreciation in the assets of the fund). The exemption is aimed at exempting from Section 1061 the gain allocated to the 1 percent capital interest.
The Proposed Regulations, unfortunately, take a strict view of this exception, and potentially limit the exception’s application to circumstances that many expected it would cover. The Proposed Regulations provide that, subject to certain carve-outs, capital interest allocations will be respected only if: (1) they are based on the relative capital accounts of partners and the terms, priority, type and level of risk, rate of return and rights to cash or property distributions are the same as other partners; (2) unrelated non-service partners own at least 5 percent of the aggregate capital account balances; and (3) the partnership agreement and all books and records clearly separately identify the capital interest allocations and the allocations with respect to Carried Interests. The requirement that capital interest allocations be based on relative capital accounts means that the exception may not apply to a wide range of circumstances, including where partners participate in deals on an investment-by-investment basis, as allocations by the fund of the gain from the sale of the investments likely will not be in proportion to capital account balances.
The Proposed Regulations exclude from a partner’s share of capital any amounts borrowed from or guaranteed by another partner, or persons related to the Carried Interest holder.
Further, the Proposed Regulations make clear that the contribution of a Carried Interest with built-in gain to another partnership’s capital will not cause gains from the partnership to which the Carried Interest is contributed to escape Section 1061, thus limiting this technique for falling within the carried interest exception.
Partnership Interests Held by Employee of Non-Investment Business
Under the Proposed Regulations, a profits interest issued by a fund to an employee of a another entity will not be a Carried Interest if such other entity does not conduct an Investment Business, either on its own or together with related persons, and the employee provides services only to such other entity. Accordingly, for example, the grant by a fund of a carried interest in the fund to an employee of a portfolio company that it owns that is engaged in an operating business should not be covered by Section 1061.
Partnership Interests Held by a Corporation
Section 1061 does not apply to partnership interests held by a corporation. As expected, the Proposed Regulations confirm earlier IRS guidance that Section 1061 may not be avoided simply by having an S corporation own the carried interest. When Section 1061 was first enacted, given that the statute provides that it does not apply to interests owned by corporations, many hoped to avoid its application by causing their carried interest to be held by an S corporation. However, in a 2018 Notice, the IRS stated its position that Section 1061 does in fact apply to a carried interest owned through an S corporation. The Proposed Regulations affirm this rule. Another structuring device that some people were considering was using a foreign corporation to hold the carried interest. If the foreign corporation was a passive foreign investment corporation, and its holders made certain elections, the thought was that the three-year holding period would not have any impact. The Proposed Regulations shut down that proposed planning technique.
Partnership Interest Purchased by Unrelated Purchaser
The Proposed Regulations add an exception pursuant to which Section 1061 does not apply to a Carried Interest acquired in a taxable purchase for its fair market value if the purchaser has not been, is not and does not anticipate becoming a service provider to (or for the benefit of) the relevant Investment Business. Accordingly, if a manager sells its Carried Interest to a third party who is not a service provider in the relevant business, then the third-party purchaser is not subject to Section 1061 with respect to that interest. This exception appears to be aimed at allowing secondary sales of interests in carry vehicles.
Family Office Exception – Future Guidance Reserved
Section 1061(b) provides that “to the extent provided [by regulations, it will] not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third party investors.” The Proposed Regulations reserve for later guidance with respect to this exception, which is intended to apply to family offices.
Once a Carried Interest …
Under the Proposed Regulations, once a partnership interest is a Carried Interest, it so remains until such time as one of the exceptions described above applies. Thus, it cannot fall outside the scope of Section 1061 if the holder stops providing services to the issuing partnership or retires, or the issuing partnership ceases to engage in an Investment Business.
Gain Acceleration on Sales to Related Parties
Under Section 1061, if a taxpayer transfers a Carried Interest to certain related persons, then the taxpayer must recognize short-term capital gain equal to the appreciation in assets with a holding period of less than three years – even where the transfer would otherwise be tax-free. Under the Proposed Regulations, related parties are generally: (1) certain family members, (2) colleagues of the Carried Interest holder (specifically, a person who provides investment advisory services within the same or preceding three calendar years to the Investment Business), or (3) a pass-through entity owned by either of the foregoing.
Carried Interest Waivers: no lines in the sand, but proceed with caution
The text of the Proposed Regulations says nothing regarding carried interest waivers. However, the preamble states the following:
The Treasury Department and the IRS are aware that taxpayers may seek to circumvent section 1061(a) by waiving their rights to gains generated from the disposition of a partnership’s capital assets held for three years or less and substituting for these amounts gains generated from capital assets held for more than three years. . . . Taxpayers should be aware that these and similar arrangements may not be respected and may be challenged under section 707(a)(2)(A), §§ 1.701-2 and 1.704-1(b)(2)(iii), and/or the substance over form or economic substance doctrines.
The Treasury and the IRS did not take a hard-line position that waivers could never work. Instead, they chose to recite the list of existing tax rules, regulations and doctrines already in their arsenal that they may rely on to take on particular waivers on a case-by-case basis. The preamble is consistent with statements IRS personnel have made at various conferences and seminars since Section 1061 was enacted and does not come as a surprise. Careful consideration should continue to be given in evaluating and structuring waivers in particular circumstances.
A taxpayer is required to provide certain information to show compliance with Section 1061. A fund that has issued a Carried Interest must provide the information needed by the taxpayer to comply with Section 1061. If the fund needs to request information from a lower-tier entity in which it owns an interest, the fund must request such information by specified dates, and the lower-tier entity must respond by the due date (including extensions) of the Schedule K-1 for the taxable year. Failure of a fund or partnership to provide this information is subject to penalties.
If a taxpayer is not provided the requisite information, the Proposed Regulations generally assume that the capital gain with respect to a Carried Interest has a less than three-year holding period, excluding capital gain is already excluded under the Proposed Regulations. Holders of Carried Interests may want to consider contractually obligating the fund to comply with the reporting requirements, and to cause the fund to have its lower tier entities comply.
The proposed regulations will not be effective until they are finalized. However, generally, they may be relied on by taxpayers before their finalization, provided the taxpayer relies on the proposed regulations in their entirety, and in a consistent manner.
The drafting of the Proposed Regulations introduces considerable complexity to the application of Section 1061. Treasury and the IRS have invited comments on the Proposed Regulations, including specifically on several aspects.