On Jan. 8, 2021, the Department of the Treasury (Treasury) and the Internal Revenue Service (the Service) issued final regulations (Final Regulations) (T.D. 9945) governing the treatment of “carried interests” (also referred to as “profits interests”) under Section 1061 of the Internal Revenue Code. That section, which was enacted under the 2017 legislation known as the Tax Cuts and Jobs Act, generally limits the availability of long-term capital gain treatment with respect to gain attributable to profits interests held for less than three years by managers of private equity, hedge and real estate funds. Carried interests, or profits interests, are partnership interests that only participate in partnership growth but have no entitlement to any of the partnership capital as of the date of grant. The Final Regulations adopt with some revisions the proposed regulations issued on July 31, 2020 (Proposed Regulations). For a detailed discussion of the Proposed Regulations, please see our Tax alert here.
Background – Section 1061
Gain from the sale of capital assets held for more than one year (long-term capital gain) is generally taxed at preferential rates (the highest such rate is currently 20%) for non-corporate taxpayers.
Section 1061 increased the requisite holding period for long-term gain preferential rates from one year to three years with respect to gain attributable to “applicable partnership interests” (APIs).
Under Section 1061, a partnership interest qualifies as an API if it is directly or indirectly transferred to or held by a taxpayer in connection with the performance of substantial services by the taxpayer (or a related person) in an “applicable trade or business” (ATB).
An ATB is generally defined as a trade or business that consists in whole or in part of both (i) raising or returning capital and (ii) investing or developing specified assets. “Specified assets” generally means securities, commodities, real estate held for rental or investment, certain derivatives, and partnership interests to the extent of such partnerships’ proportionate interests in any of the foregoing.
The Final Regulations largely retain the rules set forth in the Proposed Regulations, with some exceptions, and make a number of taxpayer-friendly clarifications and simplifications. This alert highlights important differences between the Final Regulations and the Proposed Regulations and how such differences affect funds sponsors and other taxpayers subject to Section 1061.
The Final Regulations confirm that Section 1061 applies only to gains treated as long-term capital gain under Sections 1222(3) and (4). As a result, Section 1061 does not apply to qualified dividend income, Section 1231 gains (including Section 1231 gains attributable to acquired goodwill) or gains from Section 1256 contracts. Section 1231 gain includes gain from the sale of assets (i) used in a trade or business, (ii) of a character which is subject to the allowance for depreciation and (iii) held for more than one year.
Real Estate Developers
Generally, a real estate developer’s “promote” interest will qualify as an API. However, real estate developers will not be subject to Section 1061 with respect to Section 1231 capital gain on the sale of real property assets used in a trade or business. This exclusion greatly mitigates the effect of Section 1061 on real estate developers.
Portfolio Company Dispositions
If a private equity fund disposes of a portfolio company in a transaction treated as an asset sale for federal income tax purposes, a significant portion of the gain arising therefrom could be attributable to goodwill and other Section 1231 assets (e.g., depreciable assets used in a trade or business). As mentioned above, Section 1231 gain is generally not subject to Section 1061. Therefore, private equity managers selling a pass-through portfolio investment held for less than three years may find it advantageous to structure the exit as an asset sale in order to take advantage of this exclusion. An exit that is structured as a sale of the equity interests in the portfolio company, rather than a sale of the underlying assets, would not qualify for the exclusion.
Allocations with respect to capital interests — interests in a partnership received in exchange for a capital contribution — generally fall outside the scope of Section 1061. The Final Regulations provide significant guidance with respect to the capital interest exception.
The Proposed Regulations applied a complex set of rules to determine what constitutes a capital interest. The Final Regulations adopt a more simplified rule. Allocations made to capital interests will qualify for the capital interest exception if (i) they are calculated “in a similar manner” to the allocations for unrelated non-service partners that have made “significant aggregate capital contributions” (at least 5% of the aggregate capital contributed at the time of the allocation) and (ii) the distribution rights for such capital interests and the interests held by such unrelated non-service partners are reasonably consistent with each other.
Under the Final Regulations, capital interest allocations must be “clearly identified” in a fund’s partnership agreement and books and records. As a result, fund sponsors may consider (i) amending existing agreements if necessary to clearly identify capital interest allocations and incorporate appropriate language in future agreements going forward and (ii) implementing new internal practices and procedures to properly reflect and identify capital interest allocations in their books and records.
Under the Final Regulations, taxable gain allocated to an API holder in respect of an API that is reinvested in a fund will be treated as a capital contribution so that the earnings on such amount may qualify for the capital interest exception. However, an incentive allocation on unrealized appreciation will not be treated as a capital contribution, and earnings on this “reinvested” amount will not qualify for the capital interest exception.
The foregoing clarification and distinction is particularly relevant for sponsors of hedge funds who often receive annual incentive allocations of both realized and unrealized gains. It is unclear, however, how this rule would apply to other arrangements, such as waterfall structures where an API holder receives a “catch up” allocation, followed by pro rata allocations thereafter.
Although the Proposed Regulations excluded debt-financed capital interests from qualifying for the capital interest exception, the Final Regulations provide that such interests, if financed with fully recourse debt, generally can qualify for the exception.
Gains on the Sale of APIs
If an API is sold to a third party, the API holder’s holding period in the API (rather than the partnership’s holding period of the underlying partnership assets) is generally the relevant holding period in determining whether the gain would be recharacterized as short term under Section 1061.
Application of the Look-through Rule
Notwithstanding the general rule set forth above, under the Proposed Regulations, a portion of gain from the sale of an API could be subject to Section 1061 if “substantially all” (at least 80%) of the fair market value of the partnership’s underlying assets consist of capital assets with a holding period of three years or less (the 80% Test).
The Final Regulations remove the 80% Test and limit the application of the “look-through” rule to situations in which, at the time of disposition of an API held for more than three years:
(1) the API would have a holding period of three years or less if the holding period of such API were determined by not including any period prior to the date that an unrelated non-service partner is legally obligated to contribute substantial money or property directly or indirectly to the “passthrough entity” to which the API relates, or
(2) a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under Section 1061(a).
With respect to item (1), this rule appears to target certain arrangements in which an API holder (i.e., fund sponsor) may form a fund and hold a profits interests therein long before the fund actually has investors and investments in an attempt to “age” the profits interest so that API treatment does not apply. In certain instances, this look-through rule may apply to the sale of an interest in a general partner which holds one or more APIs in underlying funds.
Capital Contributions to General Partner Entities
Under the Final Regulations, if an unrelated party purchases an API from an API holder in an arm’s length transaction, the purchased partnership interest in the hands of the unrelated purchaser would not be treated as an API (Unrelated Purchaser Exception). Under the Proposed Regulations, it was unclear whether the Unrelated Purchaser Exception would apply to an investor making a capital contribution to an entity (in a Section 721 transaction) that holds an API in an underlying fund. The Final Regulations clarify that the Unrelated Purchaser Exception does not apply to such an investor. As a result, gain allocated to such investor from the partnership’s sale of the underlying API would be subject to Section 1061. This result may come as a surprise to anchor investors in a fund that receive an interest in the fund’s general partner in connection with their investment in the fund.
Sale of Management Contracts
In the Preamble to the Final Regulations, Treasury declined to exclude from the definition of an API those financial instruments or contracts whose value is determined in whole or in part by reference to the value of a partnership. As a result, an API could theoretically include standard investment management contracts that provide for a fee based on the assets of a fund, thereby creating a risk that the sale of a management company could be subject to Section 1061, a result likely not intended by Congress. Treasury and the Service are continuing to study this issue.
The Proposed Regulations provided that if a partnership distributes property in kind to an API holder, gain from the subsequent sale of the distributed property is subject to Section 1061 unless the property has been held on a cumulative basis (whether by the partnership or the API holder) for more than three years. The Final Regulations clarify that if assets not subject to Section 1061 are distributed (such as Section 1231 or Section 1256 assets), the three-year holding requirement by the distributee partner does not apply.
Transfers to Related Parties
Under Section 1061, special rules apply if a taxpayer transfers an API to a related party. Under the Proposed Regulation, if an API is transferred to a related party, the transferor partner may recognize short-term capital gain based on a hypothetical sale of the underlying assets of the API, even if the transfer was a non-recognition transaction. As a result, transfers to related parties created an acceleration event in a transaction that would otherwise be non-taxable.
The Final Regulations clarify that Section 1061(d) does not accelerate gain with respect to all transfers to related parties and provide that the amount that may be recharacterized includes only long-term gain that the taxpayer recognizes upon a transfer through a taxable sale or exchange of an API to certain related parties.
The Final Regulations impose significant reporting requirements on partnerships that have issued APIs. Partnerships that have issued APIs will be required to implement procedures to track various items, including more-than-three-year gains, three-year-or-less gains, and “capital interest” gains and losses. If a partnership fails to report these items, it may be subject to penalties. As a result of the foregoing, investment funds can expect to incur additional administrative costs associated with new reporting requirements.
Subject to certain exceptions, the Final Regulations apply to tax years beginning on or after the date the Final Regulations are published in the Federal Register and may be relied on by taxpayers for any taxable year beginning after Dec. 31, 2017, provided that such Final Regulations are consistently applied in their entirety to such year and all subsequent years.
While the Final Regulations provide much-needed guidance on the application of Section 1061, the future of Section 1061 and the taxation of capital gains in general remains unclear. The Biden administration and a Democrat-controlled Congress may make significant tax law changes, including the elimination of preferential rate treatment for carried interest gains, regardless of holding period, and/or the implementation of a new rate structure for individual taxpayers who earn in excess of $1 million per year. Such changes could limit the ongoing significance of Section 1061.