IRS Issues Proposed Regulations Regarding the Tax Treatment of Profits Interests
On July 31, 2020, the US Internal Revenue Service (IRS) issued long-awaited proposed regulations (Proposed Regulations) regarding the federal tax treatment of certain profits interests, including carried interests, under Section 1061.1 The Proposed Regulations provide important clarifications on numerous points.
Overview of Section 1061
Congress enacted Section 1061 as part of the Tax Cuts and Jobs Act of 2017. Section 1061 effectively imposes a three-year holding period requirement to obtain long-term capital gain (LTCG) treatment (instead of the one-year holding period requirement that otherwise would apply) with respect to certain capital gain realized by a taxpayer in respect of an "applicable partnership interest" (API). An API is an interest in a partnership that is issued in connection with the performance of substantial services by the taxpayer (or a related person) in an "applicable trade or business." An "applicable trade or business" is an activity that is conducted on a regular, continuous and substantial basis, which consists, in whole or in part, of (1) raising or returning capital, and (2) investing in, disposing of, or developing certain assets, including stock, securities, commodities, and/or real estate held for rental or investment. Because private equity funds and hedge funds typically engage in an applicable trade or business, profits interests (commonly referred to as "carried interests" in this context) granted to fund sponsors in exchange for their services generally are subject to Section 1061.
Capital Gain Subject to Section 1061
The Proposed Regulations emphasize that Section 1061 applies only to items of capital gain that are characterized as LTCG or short-term capital gain (STCG) under the one-year holding period rule in Section 1222. Therefore, Section 1061 does not apply to items characterized as LTCG under other provisions, including (1) qualified dividend income taxed at LTCG rates; (2) gain from the disposition of property used in a trade or business (e.g., rental real estate) that is characterized as LTCG under Section 1231; and (3) gain derived from certain derivatives and financial contracts that is characterized as LTCG under the mark-to-market rules in Section 1256.
Holding Period Rules
Section 1061 is relevant in determining the character of any gain that is (1) realized by a partnership and allocated to any partners holding an API, or (2) realized by a taxpayer from the direct or indirect sale of an API. As a general rule, when determining the character of any gain under Section 1061, the relevant holding period is the seller's holding period in the asset sold. For example, if a partnership in which a taxpayer holds an API sells a capital asset, the partnership's holding period in the asset (rather than the taxpayer's holding period in the API) is the relevant holding period for purposes of characterizing the taxpayer's allocable share of the partnership's gain from the sale of the asset under Section 1061. If the partnership has held the asset for more than three years at the time of the sale, the taxpayer's allocable share of the resulting gain will be LTCG regardless of when the taxpayer acquired the API. Similarly, if a taxpayer directly sells an API, the relevant holding period generally is the taxpayer's holding period in the API.
The foregoing rule is subject to two exceptions. The first exception applies when (1) a taxpayer owns an API indirectly through one or more "passthrough entities" (which includes, for this purpose, partnerships, S corporations, and "passive foreign investment companies" (PFICs) with respect to which the taxpayer has a "qualified electing fund" (QEF) election in effect) and (2) the taxpayer or one of the upper-tier passthrough entities sells an interest in one of the (other) passthrough entities, thereby resulting in an indirect sale of the API. In that case, in order to avoid Section 1061, the seller and each passthrough entity below the seller must have a (direct or indirect, as applicable) holding period in the API of more than three years.
The second exception applies when there is a direct or indirect sale of an API in a partnership the assets of which (ignoring cash and cash equivalents) consist primarily (at least 80%) of capital gain assets with a holding period to the partnership of three years or less. In that situation, all or a portion of the taxpayer's gain from the sale of the API will be recast as STCG, even if the seller (and, if applicable, each underlying passthrough entity) had a holding period (directly or indirectly, as applicable) of more than three years in the API.
Lastly, the IRS was concerned that partnerships owning capital assets with a holding period of three years or less might try to circumvent Section 1061 by distributing such assets in kind, rather than selling the assets, allocating the resulting gain, and distributing the cash proceeds. Accordingly, the Proposed Regulations provide that Section 1061 will continue to apply to any capital asset with a holding period of three years or less that is distributed in kind by a partnership to an API holder, until the carryover holding period for the capital asset exceeds three years. Accordingly, if an API holder receives a distribution in kind of a capital asset with a holding period of three years or less, and immediately disposes of the asset, any gain will be recharacterized as STCG under Section 1061.
Once an API, Always an API
The Proposed Regulations provide that once a partnership interest constitutes an API, it remains an API unless and until certain exceptions apply, as discussed below. Therefore, subject to an exception, an interest in a partnership will remain an API even if (1) the taxpayer to whom the API was granted stops performing services for the partnership; (2) the taxpayer to whom the API was granted transfers the API to another party (whether by gift, bequest or sale); or (3) the partnership ceases to engage in an applicable trade or business.
APIs Held by Corporations
Section 1061 does not apply to partnership interests held, directly or indirectly, by corporations. Prior IRS guidance indicated that S corporations are not considered corporations for purposes of this exception, and the Proposed Regulations confirm this point. In addition, the Proposed Regulations provide that PFICs with respect to which taxpayers have made a QEF election also are not considered corporations for purposes of this exception.
Section 1061 does not apply to certain capital interests in a partnership that are owned by an API holder. The Proposed Regulations provide more detail regarding the scope of this exception (the Capital Interest Exception). Under the Proposed Regulations, partnership allocations (including direct and indirect allocations from underlying partnerships) based on the partners' respective capital account balances will qualify for the Capital Interest Exception only if several requirements are met:
- Such allocations must be made both to API holders and "unrelated non-service partners" (very generally, third party investors unrelated to any API holder or other person providing services in the applicable trade or business), and such "unrelated non-service partners" must have a "significant" aggregate capital account balance (an aggregate balance of 5% or more will be treated as significant).
- All such allocations generally must be made in the same manner (e.g., they must be based on the relative capital accounts of the partners and have the same type and level of risk, same rate of return, and same rights to distributions over the life of the partnership and on liquidation). Notwithstanding the foregoing, this requirement will not be breached solely because such allocations to API holders (1) are subordinated to allocations of "unrelated non-service partners" or (2) are not reduced by management fees or similar costs.
- The terms of the such allocations must be clearly identified in the partnership agreement and on the partnership's books and records as separate and apart from allocations made to an API holder with respect to its API.
The Proposed Regulation clarify that, for these purposes, capital accounts will not include contributions of amounts that are directly or indirectly attributable to loans made, or guaranteed, by other partners or the partnership (or their respective related persons). In addition, gains attributable to an API cannot benefit from the Capital Interest Exception by operation of a contribution under Section 721 or a recapitalization (even if such recapitalization is treated as a contribution under Section 721).
The Capital Interest Exception is narrower than expected, and may create challenges for fund sponsors and others attempting to benefit therefrom. In particular, the requirement for all allocations in respect of capital interests to be made in the same manner may create issues in practice. By way of example, fund sponsors that utilize an "American waterfall" structure make allocations on an investment-by-investment basis (instead of an aggregate fund basis). In such a situation, partners will receive allocations in respect of capital interests based on their respective capital contributions with respect to each individual investment, rather than their respective aggregate capital accounts. Therefore, it may be difficult for such a fund to satisfy the Capital Interest Exception.
Sales for Fair Market Value to Unrelated Third Party
If an API holder sells an API for fair market value, in a taxable transaction, to an unrelated third-party who has not, does not, and will not perform services for the partnership, the transferred partnership interest will not be treated as an API with respect to the purchaser.
Following the enactment of Section 1061, many partnerships have utilized "carry waivers," pursuant to which holders of APIs waive their right to STCG allocations in exchange for a larger share of LTCG allocations in the future when the requisite three year holding period is met. Although the Proposed Regulations do not address carry waivers explicitly, the preamble thereto makes clear that they (and similar arrangements) are subject to scrutiny and may not be respected.
Related Party Transfers
Under Section 1061, a taxpayer who transfers (including, without limitation, by way of a contribution, distribution, gift, sale or exchange) an API to a "related person" may be required to recognize STCG on the transfer, even if the taxpayer otherwise would not recognize any gain on the transfer (the Related Person Rule). For purposes of this rule, a "related person" generally is a person who (1) is a family member of the taxpayer or (2) has performed services for any applicable trade or business for which the taxpayer also has performed services within the calendar year or the preceding three calendar years, as well as any passthrough entity in which such person holds an interest. The amount of STCG required to be recognized under this rule is equal to the excess of (a) any net LTCG from assets held for three years or less which would have been allocated to the transferor upon a hypothetical sale of all partnership assets, over (b) any amount recharacterized as short-term capital gain under Section 1061 on the transfer. The Proposed Regulations clarify that the Related Person Rule applies even in the event that the transfer would otherwise qualify for tax-free treatment, except for partnership contributions under Section 721, which are exempt.
The Proposed Regulations provide that API holders must report such information as the IRS may require to demonstrate that the holders have complied with Section 1061. Passthrough entities in which, or through which, a taxpayer holds an API also will be obligated to complete additional tax information reporting (likely in the form of an attachment to Schedule K-1) in order to ensure compliance with Section 1061. Passthrough entities that fail to complete such reporting will be subject to penalties. In addition, a taxpayer that does not receive such information from a passthrough entity generally will be required to treat its allocable share of capital gain as STCG, unless the taxpayer is able to otherwise substantiate alternative treatment for all or part of such amounts to the satisfaction of the IRS.
The Proposed Regulations generally will apply to taxable years beginning on or after the date final regulations are published. However, taxpayers generally may rely on the Proposed Regulations pending finalization, provided they follow them in their entirety and in a consistent manner. In addition, the rule excluding S corporations from the Section 1061 exception for APIs held by corporations applies to taxable years beginning after December 31, 2017.
© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.