The IRS recently published FAQs providing guidance on the tax reporting requirements for holders of carried interests and certain pass-through entities with respect to Section 1061.
Section 1061 was added to the IRC as part of the Tax Cuts and Jobs Act in 2017 and limits the favorable tax treatment available to holders of so-called “carried interests”—certain compensatory partnership profits interests frequently issued in the private equity, hedge fund, and real estate industries. Section 1061 changes the holding period requirement for long-term capital gains attributable to an “applicable partnership interest” from one year to three years.
The Treasury and IRS issued final regulations implementing Section 1061, which are effective for tax years beginning after Jan. 19, 2021, unless a taxpayer elects to apply the final regulations for an earlier tax year. See our prior story for more information on the Section 1061 final regulations here. Notably, Treas. Reg. Sec. 1.1061-6 provides that both holders of applicable partnership interests—so-called “owner taxpayers” (generally individuals, trusts, and estates)—as well pass-through entities impacted by Section 1061 must provide information as the IRS may require in forms, instructions, or other guidance as is necessary to determine they have complied with Section 1061 and the Section 1061 regulations. It appears the recently published FAQs provide a portion of this guidance.
The FAQs provide guidance on tax filing requirements for both owner taxpayers and pass-through entities for taxable years subject to the final Section 1061 regulations. The FAQs require pass-through entities to provide a worksheet containing information pertaining to the computations required by the Section 1061 regulations to the holders of applicable partnership interests as an attachment to the Schedule K-1 for the applicable form, notating the proper box and code. For the Form 1065, U.S. Return of Partnership Income, it is Box 20, Code AH. For the Form 1120S, U.S. Income Tax Return for an S Corporation, it is Box 17, Code AD. For the Form 1041, U.S. Income Tax Return for Estates and Trusts, it is Box 14, Code Z.
The FAQs also provide guidance to owner taxpayers on how to compute the amount of long-term capital gains that are recharacterized as short-term capital gain pursuant to Section 1061, and how to report the recharacterized amounts on an owner taxpayer’s tax return. The FAQs provide a worksheet and accompanying tables that must be included in an owner taxpayer’s tax return for taxable years subject to the final regulations. The information required to be included within the worksheets for both pass-through entities and owner taxpayers follows the defined terms and computations utilized in the final Section 1061 regulations.
The FAQs also appear to impact tax reporting requirements for calendar-year taxpayers for the 2021 taxable year—including taxpayers that do not choose to apply the final Section 1061 regulations. For tax returns filed after Dec. 31, 2021, that do not apply to the final Section 1061 regulations, the FAQs require a worksheet containing information similar to the worksheets provided by the FAQs to be included with an applicable partnership interest holder’s Schedule K-1 in the case of a pass-through entity, or filed with an owner taxpayer’s tax return, and in each case the tax return must disclose that an alternative method to the Section 1061 regulations was used (e.g., the proposed Section 1061 regulations). This is noteworthy because the worksheets provided by the FAQs incorporate many of the defined terms and computations included in the final Section 1061 regulation, which a calendar year taxpayer is not required to apply to its 2021 taxable year.
The Section 1061 FAQs provide helpful guidance on how to incorporate Section 1061 information into tax returns subject to the final Section 1061 regulations. It remains to be seen whether there will be future developments as to the FAQs application to tax returns that are not subject to the final Section 1061 regulations. Although taxpayers have been required to report information pertaining to Section 1061 for prior tax years, compiling information as required by the FAQ worksheets could nevertheless present a significant compliance burden for calendar-year taxpayers for their 2021 tax year.
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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