The IRS released final regulations (T.D. 9945) on Jan. 7, 2021, providing guidance on the carried interest rules under Section 1061. The final regulations generally retain the structure of proposed regulations issued last July but also make several important changes.
Section 1061 was enacted as part of the Tax Cuts and Jobs Act (TCJA) and requires a three-year holding period to qualify for long-term treatment on certain capital gains arising from an applicable partnership interest (API). An API is a partnership interest held by or transferred to a taxpayer in connection with a performance of substantial services by the taxpayer or any related person in an applicable trade or business (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. The IRS issued proposed regulations in July 2020 providing guidance on numerous issues under Section 1061. For an explanation of the proposed regulations, see our prior coverage.
The final regulations make notable changes to:
- The capital interest exception
- The treatment of capital interests acquired with loan proceeds
- The look through rule for certain API dispositions
- Transfers of APIs to Section 1061(d) related persons
They also provide numerous other clarifications and indicate that the IRS will continue to study related issues.
Taxpayers should carefully analyze the final regulations in their entirety to assess the potential impact, in particular, because only certain revisions from the proposed regulations are discussed herein. Also, the regulations contain numerous defined terms that need to be read together. Taxpayers should also monitor any further developments. Although the final regulations were published in the Federal Register just prior to the regulation freeze imposed by the new administration and are generally in effect, they may nonetheless be subject to review.
Capital interest exception
The final regulations simplify the capital interest exception under Section 1061(c)(4)(B), which provides that an API does not include “any capital interest in the partnership which provides the taxpayer with a right to share in partnership capital commensurate with 1) the amount of capital contributed (determined at the time of receipt of such partnership interest) or 2) the value of the interest included in income under Section 83 upon the receipt or vesting of such interest.”
Under the proposed regulations, only allocations that are made “in the same manner” to all partners could be capital interest allocations or passthrough interest capital allocations. This would mean 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.
Comments received on the proposed regulations for the capital interest exception indicated that the proposed regulations were too rigid and would result in many capital interest holders not being eligible for the capital interest exception because the rules did not reflect many common business arrangements. In response, the IRS simplified the capital interest exception by providing that an allocation is a capital interest allocation if “the allocation to the API holder with respect to its capital interest is determined and calculated in a similar manner to the allocations with respect to capital interests held by similarly situated unrelated non-service partners who have made significant aggregate capital contributions.”
The final regulations also extend this simplicity and the same principles to tiered structures. For a passthrough entity that holds an API in a lower-tier passthrough entity, an allocation made to the upper-tier passthrough entity will be considered a capital interest allocation “if made in accordance with the principles applicable in determining capital interest allocations.” These capital interest allocations will retain their character when allocated up the tiered structure if they are “allocated among the partners in the upper-tier partnership with respect to such partners’ capital interests in a manner that is respected under Section 704(b).”
Additionally, the final regulations remove the proposed regulations’ mandatory revaluation rule for tiered partnership situations, The proposed regulations contained a requirement for partnerships to determine unrealized API gains and losses in tiered-partnership situations, in some instances requiring an upper-tier passthrough entity to require the lower-tier passthrough entities in which it holds an equity interest to perform a revaluation of their assets. A commenter noted that this requirement was not reasonable because an upper-tier passthrough entity would not be able to require every uncontrolled lower-tier passthrough entity in the chain to revalue its assets. In response, the final regulations eliminate this mandatory revaluation requirement and instead provide that existing rules governing unrealized gains and losses, including Section 704(c) principles, should be applied to determine unrealized API gains and losses.
Capital contributions rule is relaxed
The final regulations relax the rule that a capital account does not include the contribution of amounts that are attributable to any loan made by another partner, the partnership or a related person.
The proposed regulations provided that repayments on the loan are included in capital accounts as those amounts are paid by the partner, provided that the loan is not repaid with the proceeds of another similarly sourced loan. Though many commenters raised objections on various grounds, including that the proposed rule would inhibit common and reasonable business practices, the IRS expressed concern that capital contributions made with the proceeds of loans made or guaranteed by another partner, the partnership or a related person could lead to abuse of the capital interest exception, and declined to remove the rule.
However, the IRS relaxed the rule, explaining that the potential for abuse is reduced when a loan or advance is made by another partner or related person to an individual service provider if the individual service provider is personally liable for the repayment of the loan or advance. Thus, the final regulations provide that an allocation will be treated as a capital interest allocation, even if the allocation is attributable to a contribution made by an individual service provider that results from, or is attributable to, a loan or advance from another partner in the partnership (or any related person with respect to such lending or advancing partner, other than the partnership) to such individual service provider, or if the individual service provider is personally liable for the repayment of such loan or advance as described in the final regulations.
In order to determine whether the individual service provider is personally liable, the final regulations require that 1) the loan or advance is fully recourse to the individual service provider, 2) the individual service provider has no right to reimbursement from any other person, and 3) the loan or advance is not guaranteed by any other person.
Look-through rule for certain API dispositions
The final regulations scale back the application of the look-through rule for certain API dispositions. Under the proposed regulations, the general rule when applying Section 1061(a) is that the holding period taken into account is the direct owner’s holding period in the asset sold, whether that is the partner’s holding period in the partnership interest or the partnership’s holding period in an underlying asset.
However, the proposed regulations also contained a look-through rule, which provided that if gain with respect to “substantially all” (80% or more) of an entity’s assets would be recharacterized as short-term under Section 1061 if disposed of (due to a holding period of three years or less), then gain on the sale of such API would be recharacterized as short-term even if the seller of the API had satisfied the three-year holding period generally required by Section 1061.
The look-through rule was noted by commentators as imposing a significant administrative burden in tiered structures. The final regulations thus provide that the look-through rule instead applies where, at the time of the disposition of the API which has been held more than three years, either:
- The API would have a holding period of three years or less if the determination of the holding period of the API did not include any time prior to when an unrelated non-service partner is legally obligated to contribute substantial money or property to the passthrough entity to which the API relates
- A transaction, or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under Section 1061(a)
The look-through rule applies to a passthrough interest issued by an S corporation or a passive foreign investment company (PFIC) to the extent the passthrough interest is treated as an API.
Transfers to related parties
The final regulations limit the scope of the rule concerning transfers to related parties under Section 1061(d). Under the proposed regulations, if an “owner taxpayer,” as defined in the guidance, transfers any API to a related person or the passthrough entity in which an owner taxpayer holds an interest transfers an API to a related person, the owner taxpayer may recognize gain even if the code otherwise classifies the transfer as a nonrecognition event. The proposed regulations further provide that a transfer includes contributions, distributions, sales and exchanges and gifts.
Commenters had addressed whether Section 1061(d) should be interpreted as an acceleration provision or merely a recharacterization provision. The final regulations recognize that interpreting Section 1061(d) as only a recharacterization provision is consistent with the statute. As such, they provide that gain will be recognized on a transfer to a related person, either by the owner taxpayer or the passthrough entity through which the owner taxpayer owns an API, only when long-term capital gain is recognized under Chapter 1 of the code for the transfer. The regulations will no longer extend this rule to encompass nonrecognition transfers.
The final regulations generally apply to tax years of owner taxpayers and passthrough entities beginning on or after Jan. 19, 2021. There are exceptions to the general effective date rule, notably for the provision on an S corporation not being treated as a corporation for purposes of Section 1061 (tax years beginning after Dec. 31, 2017) and for a similar provision for a PFIC with respect to which a qualified electing fund election is in effect (tax years beginning after Aug. 14, 2020). An owner taxpayer or passthrough entity may choose to apply the final regulations in their entirety to a tax year beginning after Dec. 31, 2017, so long as the final regulations are applied in their entirety to that tax year and all subsequent tax years.
The final regulations were published in the Federal Register on Jan. 19, 2021, the day before the new administration’s memorandum imposing a freeze on new regulations pending review by the new administration. Thus, they are not required to be withdrawn, but are in the category of regulations that may be postponed for 60 days (from Jan. 20, 2021). Additionally, the new administration could still review and revisit any prior guidance, subject to applicable limitations in the Administrative Procedures Act and Section 7805.
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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