The IRS has issued proposed regulations (REG-107213-18) on the new holding period for carried interest under Section 1061, providing much-awaited guidance on numerous issues, but also leaving several questions unanswered.
Section 1061 was enacted as part of the Tax Cuts and Jobs Act (TCJA) and generally increases the long-term holding period to receive long-term capital gains treatment on certain partnership interests from more than one year to more than three years. The rules apply to partnership interests issued in connection with the performance of substantial services, and they affect carried interest arrangements, including carried interests in many private equity and alternative asset funds (e.g., hedge funds, real estate).
The proposed regulations provide detailed reporting requirements and rules and terms for applying Section 1061, which is applicable to taxable years beginning after Dec. 31, 2017. The regulations are proposed to apply to taxable years beginning on or after the date final regulations are published in the Federal Register, but there are limited exceptions for partnership interests held by S corporations and certain passive foreign investment companies (PFICs). Most taxpayers also have the option of applying the proposed regulations for taxable years beginning before but should carefully weigh the impact of doing so. As discussed later, the proposed regulations add an exception and provide a transition rule that could be an incentive to certain taxpayers to apply the proposed regulations before the guidance is finalized.
The proposed regulations are complex and should be analyzed carefully for their application and implications. Partnerships will need to be especially mindful of holding period considerations when considering both asset disposition and acquisition transactions, as well as other monetization considerations.
Section 1061 recharacterizes certain long-term capital gains with respect to an applicable partnership interest (API) as short-term capital gains by applying a three-year holding period instead of a one-year holding period. An API is a partnership interest held by, or transferred to, a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer or a related person in any applicable trade or business (ATB).
However, the statute is unclear on its face as to whether the recharacterization applies to gains arising from the partner’s disposition of its partnership interest, the partner’s distributive share of the gain from a disposition of certain assets by the partnership, or both, as it does not specify the actual asset from which the capital gain in issue arises. The proposed regulations address this issue, providing specific gains that are included and excluded from API (described in detail below).
Any long-term capital losses (determined as if a three-year holding period applies) are also taken into account in these calculations. Certain capital interests, interests held by a corporation and interests held by a person who only provides services to another entity are excluded from API. Also, a transfer of an API to a related person would accelerate the recognition of a capital gain in a transaction that would be an otherwise nontaxable event.
Overview of the proposed regulations
The proposed regulations institute a “once an API, it remains an API” concept. Under this approach, a partnership interest would need to be continually tested to determine if and when it becomes an API. Once this threshold is crossed, the partnership interest generally remains an API even if it is contributed, distributed or otherwise transferred to another taxpayer or entity, even if the partner no longer provides services to the partnership. The API taint can only be overcome when one of the Section 1061 exceptions (discussed below) is met or if an unrelated person purchases the partnership interest for its fair market value (FMV) and has not and does not anticipate providing services in the future.
The proposed regulations take into account that APIs may be owned by persons both directly and indirectly via passthrough entities. Thus, the proposed regulations provide guidance for the following parties to an arrangement. The proposed regulations define terms as follows:
- Owner taxpayer: The partner ultimately liable for any taxes with respect to an API
- Passthrough entity: Each passthrough entity that is a part of the ownership structure
- Passthrough taxpayer: A passthrough entity treated as a taxpayer for purposes of determining the existence of an API.
- API holder: Each person or entity that holds an API.
The preamble to the proposed regulations explains that there may be one or more tiers of pass-through entities between the partnership that originally issued the API and the pass-through entity in which the owner taxpayer holds its indirect interest in the API. The preamble explains further that each pass-through entity in the tiered structure is treated as holding an API under the proposed regulations. That is, each pass-through entity is an API holder, and an API Holder may be an individual, partnership, trust, estate, S corporation or a PFIC with respect to which the shareholder has a qualified electing fund (QEF) election in effect.
Gains (including gains from installment sales) from APIs subject to recharacterization under Section 1061 include a distributive share of the partnership’s long-term capital gain, long-term capital gain from the disposition of the partnership interest and long-term capital gain from the disposition of property distributed to the partner from a lower-tier entity. Notwithstanding the general broad scope, the proposed regulations explicitly exclude certain gains from recharacterization:
- Section 1231 gains and losses
- Section 1256 gains
- Qualified dividends under Section 1(h)(11)
- Capital gains under identified mixed straddle rules described in Section 1092(b)
The exclusion of Section 1231 gains and losses was a much-desired result, confirming the views of some taxpayers that their exclusion was already implicit under the language of the statute.
Though the relevant holding period under the proposed regulations generally is the holding period of the asset disposed of (e.g., the API), the proposed regulations include a limited look-through rule, which could recharacterize a portion of the greater-than-three-year capital gain on a taxable API disposition to short-term capital gain. The look-through rule applies if substantially all (defined as 80% or more) of the FMV of the applicable partnership’s assets consist of capital assets with a holding period of three years or less. In this computation, cash, cash equivalents, and Section 751 unrealized receivables and inventory items are not taken into account in the numerator. If an upper-tier partnership has a greater-than-three-year holding period in its interest in a lower-tier partnership, the upper-tier partnership must treat the interest as having a short-term holding period to the extent the lower-tier partnership's assets consist of capital assets with a one-to-three year holding period.
The proposed regulations also provide a transition rule that allows eligible partnerships to irrevocably elect to exclude long-term capital gains and losses of certain property held by the partnership from recharacterization under Section 1061. The transition rule applies to capital gains and losses from the disposition of all assets that were held for more than three years as of Jan. 1, 2018, by a partnership that was in existence as of Jan. 1, 2018. Such amounts are referred to as “partnership transition amounts.” The partnership must make a signed and dated election by the due date (including extensions) of its Form 1065 for the first partnership taxable year in which it wishes to apply the transition rule. The election applies for the taxable year that the election is made and all subsequent taxable years. A partnership may rely on the proposed regulations to make the election for taxable years beginning in 2020 or in a later year.
Computing the recharacterization amount
Under the proposed regulations, the amount that the taxpayer must treat as short-term capital gain under Section 1061 is referred to as the “recharacterization amount.” The recharacterization amount is the amount by which the taxpayer’s “one-year gain amount” exceeds its “three-year gain amount.”
The one-year gain amount has two components: 1) the taxpayer’s combined distributive share of net one-year gains from all its APIs held during the taxable year, and 2) the taxpayer’s net one-year gain from the taxable disposition of an API (including sales, exchanges, and distributions in excess of outside tax basis) or property distributed to it from an API.
Similarly, the three-year gain amount has two components: 1) the taxpayer’s combined distributive share of net three-year gains from all its APIs held during the taxable year, and 2) the taxpayer’s net three-year gain from the taxable disposition of an API or property distributed to it from an API.
Who is subject to Section 1061?
As noted above, the proposed regulations indicate that Section 1061 could apply to both the passthrough entities (pass-through taxpayers) and their owners (owner taxpayers). The proposed regulations define an owner taxpayer as any person subject to tax on the net gain with respect to an API and is the person that computes the recharacterization amount. Owner taxpayers include individuals, simple and complex trusts, and estates. A passthrough taxpayer is defined as any entity that itself does not generally pay tax (e.g., partnerships and S corporations).
Both owner taxpayers and pass-through taxpayers are considered taxpayers for purposes of determining whether an API exists. To determine whether an API is present, a pass-through taxpayer can itself be the service provider (or related to the service provider), engaged in an ATB or the recipient of a partnership interest in connection with the performance of substantial services in an ATB. Under Section 1061, an ATB is any activity conducted on a regular, continuous, and substantial basis which consists, in whole or in part of 1) raising or returning capital and 2) either investing in, disposing of, or developing specified assets. If a pass-through taxpayer is the recipient of the API, its ultimate owners (other than owners excepted from Section 1061, such as C corporations) are treated as owner taxpayers for purposes of computing the recharacterization amount.
What is an API?
The proposed regulations reflect a broad view of the interests that constitute an API. Solely for purposes of Section 1061, an API includes any financial instrument or contract in which the value 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.
Under Section 1061(c)(1), an interest in a partnership is an API if the interest is transferred to or held by the taxpayer in connection with the performance of “substantial” services by the taxpayer or a related person in an ATB. The proposed regulations provide that if a taxpayer provides any services in an ATB and an allocation of a partnership’s profits is transferred to or held by the taxpayer in connection with those services, then those services will be presumed to be substantial for purposes of Section 1061.
This presumption reflects a broad approach to the services that will cause a partnership interest to be an API. Additionally, the proposed regulations do not provide for any means to overcome the presumption. The IRS explains in the preamble to the proposed regulations that the presumption is appropriate because “the parties to the arrangement have economically equated the potential value of the interest granted with the value of the services performed.” However, it is seeking comments on the presumption, specifically what level of insubstantial services should overcome the presumption.
What is not an API?
In addition to a partnership interest acquired in a taxable transaction by an unrelated purchaser, there are three exceptions to treating a partnership interest as an API:
- An interest in a partnership issued to a person who is employed by another entity that is not conducting an ATB and provides services only to the other entity.
- A partnership interest held by a corporation. The proposed regulations would codify guidance previously issued by the IRS (Notice 2018-18) that a partnership interest held by an S corporation is not eligible for this exception. Notably, this rule is effective for tax years beginning after Dec. 31, 2017. The proposed regulations also provide that a partnership interest held by a PFIC with a QEF election in effect is not eligible for this exception. This rule is proposed to be effective for tax years beginning after the date the proposed regulations are published in the Federal Register.
- “Any capital interest in the partnership which provides the taxpayer with 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 the interest subject to tax under Section 83 upon receipt or vesting of such interest.”
The proposed regulations provide a detailed set of rules and terms for addressing the capital interest exception. Under the proposed regulations, capital interest gains and losses are not subject to Section 1061 and are comprised of three amounts: capital interest allocations, pass-through interest capital allocations and capital interest disposition amounts.
Only allocations that are made “in the same manner” to all partners can be capital interest allocations or passthrough interest capital allocations. This means that generally, allocations (under the partnership agreement) are based on relative capital accounts of the partners that are receiving the allocation and the terms, priorities, type and level of risk, rate of return, rights to cash or property distributions during the operations and on liquidation are the same.
Additionally, the allocations must be based on the capital accounts as determined and maintained under the Section 704(b) regulations (or in a manner similar to the Section 704(b) regulations if the passthrough entity is not a partnership or is a partnership that does not maintain capital accounts). The proposed regulations indicate that an allocation would not fail to meet this exception solely because it is subordinated to an allocation to unrelated non-service partners or because it is not reduced by the cost of services provided by the owner of the API or a related person.
A capital interest disposition amount is the amount of long-term capital gain and loss recognized on the sale or disposition of all or a portion of a pass-through interest that may be treated as capital interest gain or loss.
When is an ATB present?
The proposed regulations provide that an ATB is any activity for which the ATB Activity Test with respect to specified actions is met. Specified actions include “raising or returning capital actions” (i.e., actions involving raising or returning capital but not including “investing or developing actions”) and investing or developing actions (i.e., actions involving either 1. investing in, or disposing of, specified assets [or identifying specified assets for such investing or disposition], or 2. developing specified assets). Under Section 1061, specified assets are securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing.
The proposed regulations peg the ATB Activity Test to Section 162. Under the proposed regulations, the ATB Activity Test is satisfied if specified actions are conducted by one or more related persons and the total level of activity, including the combined activities of all related persons, satisfies the level of activity that would be required to establish a trade or business under Section 162. Additionally, the proposed regulations indicate that it is not necessary for both the raising or returning capital actions and investing or developing actions to be conducted in the same taxable year for an ATB to exist in that year.
Unrealized gains and losses and required revaluations
In addition to recharacterizing long-term capital gains recognized with respect to an API, the proposed regulations require that unrealized capital gains and losses that would be allocated with respect to an API upon the revaluation or contribution of partnership property (e.g., in the case of a passthrough entity that contributes property to another passthrough entity, or in the case of a contribution of an API to a pass-through entity) be determined and identified by requiring that a revaluation be computed for Section 1061 purposes by applying the principles under the Section 704(b) regulations. The revaluations would need to be made through each applicable tier of partnerships. These rules apparently are intended to ensure that the identified unrealized gains and losses are not later converted to long-term capital gain or loss attributable to a capital interest.
Since a revaluation would be required to comply with Section 1061, a partnership would be permitted to also revalue its property for purposes of Section 704(b) as though an eligible event had occurred. The proposed regulations could significantly increase the number of revaluations that partnerships would need to perform, which generally require the determination of fair market value and adjusted basis of every partnership asset and liability on such a date.
Transfers to related persons
Section 1061(d)(1) provides that if a taxpayer transfers an API, directly or indirectly, to a person related to the taxpayer, the taxpayer shall include in gross income (as short-term capital gain) the excess (if any) of:
A) so much of the taxpayer’s long-term capital gains with respect to such interest for such taxable year 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 such interest.
A commentator suggested that the IRS suspend the application of Section 1061(d) until Congress clarifies its application. However, the IRS explained in the preamble that they did not believe a suspension is necessary. Instead, they interpreted Section 1061(d)(1) to require that gain equal to the amount described in that section be recognized and included in income as short-term capital gain on the transfer of an API to a Section 1061(d) related person even if the transfer is not a transaction in which gain is otherwise recognized under the Code.
Under the proposed regulations, the IRS would require that long-term capital gain be accelerated and included in income of a taxpayer as short-term capital gain if an API is transferred to a related person. This rule applies even if the transfer is a transaction that would not have otherwise caused recognition of gain. Transfers would include, but not be limited to, contributions, distributions, sales, exchanges and gifts.
However, a contribution to a partnership under Section 721(a) is not treated as a transfer subject to this rule since the proposed regulations would require that the unrealized gain at the time of the contribution be allocated to the holder of the API when later recognized.
A related person for this purpose includes family members within the meaning of Section 318(a)(1) or a person who performed services within the current calendar year or any of the preceding three calendar years in the same ATB in which the transferor performed a service.
Under the proposed regulations, the amount of gain required to be included by an owner taxpayer as short-term capital gain under this transfer to related parties rule is the excess, if any, of the owner taxpayer’s net long-term capital gain with respect to the transferred API for the taxable year, over the amount of long-term capital gain recognized on the transfer that is treated as short term capital gain under Section 1061(a). The proposed regulations further provide that an owner taxpayer’s net long-term capital gain with respect to a transferred API for this purpose is the amount of net long-term capital gain from assets held for three years or less (including any remedial allocations under Treas. Reg. Sec. 1.704-3(d)) that would have been allocated to the partner if the partnership had sold all of its property in a fully taxable transaction for FMV immediately before the transfer. If this amount is negative or zero, then no gain would be recognized under the transfer to related parties rule.
Special rule for installment sales
In the case of an installment sale, the proposed regulations confirm that the holding period of the asset on the date of its disposition is used for purposes of applying Section 1061, regardless of when the cash actually is received. The preamble to the proposed regulations explains that this rule is consistent with the manner in which installment sales are treated under existing law. The preamble also illustrates the rule via an example of an API that was sold on Nov. 30, 2017, (which is before the effective date of Section 1061) and had a holding period of two years. The preamble explains that the gain recognized on or after Jan. 1, 2018, is subject to Section 1061 even though the disposition took place before the effective date of Section 1061.
The proposed regulations include an amendment to the Section 704(c) aggregation rules with regard to securities partnerships. Under the current Section 704(c) regulations, a securities partnership may aggregate gains and losses from qualified financial assets using any reasonable approach that is consistent with the purpose of Section 704(c). The proposed regulations provide that an approach will not be considered reasonable if it fails to take into account the application of Section 1061 in an appropriate manner.
The proposed regulations adopt the approach that the holding period of the owner of the asset controls. Further, the proposed regulations amend the holding period rules in Treas. Reg. Sec. 1.1223-3 to clarify how to calculate the holding period when the API comprises a portion of the partnership interest and the partnership interest has a divided holding period.
This clarification applies to the calculation of all profits interests and all APIs. Though the general rule in Reg. Section 1.1223-3(b)(1) is that holding periods are determined based on relative FMVs determined immediately after the acquisition of a partnership interest, in the case of a partnership interest that has a divided holding period and the partnership interest includes a profits interest, the relative FMV of the profits interest is determined at the time of the interest’s disposition (or partial disposition). The preamble to the proposed regulations adds that no inference is intended with respect to the valuation of a profits interest that fails to meet the safe harbor under Rev. Proc. 93-27 (as clarified in Rev. Proc. 2001-43).
The proposed regulations include reporting provisions. An owner taxpayer must report any information that the IRS Commissioner may require in forms, instructions or other guidance to evidence the taxpayer’s compliance with Section 1061. Pass-through entities must provide owner taxpayers information needed by the owner taxpayer to comply with Section 1061. A pass-through entity that has issued an API must provide information to the holder of the API necessary to determine the one-year gain and three-year gain (described above). This includes the distributive share of net one-year gains and net three-year gains attributable to the API as well as the amounts attributable to a capital interest. If an upper-tier passthrough entity requires information from a lower-tier entity in order to fulfill its Section 1061 reporting requirements, the passthrough entity must request the information from the lower-tier entity by the later of 30 days after the end of its taxable year or 14 days after the date of a request for information from an upper-tier passthrough entity. The lower-tier entity must furnish the information by the due date (including extensions) of the Schedule K-1 for the taxable year.
Interaction with Rev. Proc. 93-27 profits interest safe harbor
The preamble to the proposed regulations states that a partnership interest may be treated as an API regardless of whether the receipt of the interest satisfies the requirements of Rev. Proc. 93-27, which sets forth an administrative safe harbor for the tax-free receipt of profits interests or carried interests for the provision of services in a partner capacity or in anticipation of being a partner if certain requirements are met (including, but not limited to, the partner not disposing the profits interest within two years of receipt).
Recapitalizations and divisions
The preamble to the proposed regulations explains that the IRS is aware that some taxpayers have taken the position that a recapitalization or a division is a capital contribution under Section 1061(c)(4)(B) that would allow taxpayers to recharacterize what would be API gains as capital interest gains, which would not be subject to Section 1061. The IRS recognizes that a recapitalization or a division may be treated as a Section 721 contribution, but they “would not have the effect of recharacterizing API gains and losses as capital interest gains and losses under these proposed regulations.”
The IRS also discusses fee waivers in the preamble, but the proposed regulations’ text does not include any provision addressing fee waivers. The preamble discusses several techniques for waiving rights to income or gain with regard to assets held for three years or less and substituting with income or gains generated from assets that would not be subject to Section 1061 recharacterization. The preamble cautions that fee waiver strategies may be challenged under various grounds, including Reg. Section 1.704-1(b)(2)(iii), Section 707(a)(2)(A), the partnership anti-abuse rule in Reg. Section 1.701-2, and the economic substance doctrine.
The proposed regulations clearly cover many bases and reflect thoughtful ways of filling in the gaps for a statute that has some ambiguities and interpretational challenges. Some of the positions taken in the proposed regulations, such as the exclusion of S corporations from the exception for corporations, are not surprises. However, many of the rules in the proposed regulations are very detailed and complex and warrant deep study for their application and implications. When considering both asset disposition and acquisition transactions, partnerships will need to be especially mindful of holding period considerations. For example, add-on investments in portfolio companies structured as C corporations or partnerships may have implications relating to split holding periods. Additionally, it will be useful to watch for comments on the proposed regulations to evaluate the parts that may be revised when they are finalized.
Practice Leader, Tax Technical, Washington National Tax Office
Grace Kim has more than 20 years of experience in the area of partnership taxation, which includes IRS, law firm and accounting firm positions. Her diversified experience includes working on a broad range of structuring and operational issues in a variety of industries and areas.
Washington DC, Washington DC
- Real estate and construction
- Private equity
- Strategic federal tax
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