On January 7, Treasury released final regulations (the “Final Regulations”) regarding the taxation of profits interest (commonly known as a “carried interest” or a “promote”) under Section 1061 of the Internal Revenue Code (the “Code”). The Final Regulations retain the basic structure of the proposed regulations issued this past summer (the “Proposed Regulations”) but offer a few taxpayer-friendly modifications.
Investment partnerships, such as hedge funds, private equity funds and real estate and other syndications (each referred to herein as a “fund”), typically compensate their fund managers, developers or sponsors (each a “service partner”) by granting a right to future profits of the partnership, the “carried interest” or a “promote”. The issuance of the caried interest or promote is usually not taxable to the service partner, and gain recognized by the fund from its investments and allocated to the service partner may be taxed at favorable long‑term capital gain rates, provided other conditions are met.
In 2017, Congress enacted Section 1061 of the Code as part of the Tax Cuts and Jobs Act. Section 1061 generally extends the holding period required to qualify for long-term capital gain treatment from 1 to 3 years with respect to gains related to an “applicable partnership interest” (“API”). Section 1061(c)(1) defines an API as any interest in a partnership which is held by a taxpayer in connection with the performance of services in any applicable trade or business (“ATB”), defined generally as (A) raising or returning capital, and (B) investing in or developing specified assets. Section 1061(c)(3) defines “specified assets” as securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and interests in partnerships to the extent of the partnerships’ proportionate interests in any of the foregoing. Most investment partnerships fall within this definition, and therefore a fund manager, sponsor or developer that receives a carried interest or promote from a fund will more than likely be subject to the rules of Section 1061.
Below are certain significant revisions in the Final Regulations:
Capital Interest Exception
Capital interests are exempt from recharacterization under Section 1061 to the extent that they represent a return on the capital invested in the fund, also known as the “capital interest exception.” The Final Regulations provide that in order for a taxpayer to rely on the capital interest exception to Section 1061, an allocation to a holder of an API with respect to its capital interest must be determined and calculated in a similar manner (commensurate with capital contributed) as the allocations with respect to capital interests held by similarly situated “unrelated non-service partners” who have made significant capital contributions, as clearly identified in the partnership agreement and the partnership’s books and records.
The Final Regulations also provide that an interest may be a capital interest even if funded by a loan or advance from another partner in the partnership (or any related person other than the partnership) to such individual service partner, provided that (i) the loan is fully recourse to the individual service partner, (ii) with respect to which the individual service partner has no right to reimbursement from any other person, and (iii) the loan is not guaranteed by any other person.
Practice Note: Service partners relying on the capital interest exception should review their applicable partnership or LLC agreements to ensure that such agreements meet the clear identification requirements of that exception.
Holding Periods on Gains on the Sale of APIs and Distributed API Property
The holding period of a partner’s API determines the treatment on the sale of the API, however, the Proposed Regulations provided a limited exception that required looking through to the holding period of the underlying partnership assets for partnerships that meet the so-called “Substantially All Test.” The Substantially All Test was met if 80% or more of the assets of the partnership in which the API is held (excluding certain net working capital assets and inventory), based on fair market value, are capital assets that have a holding period of 3 years or less. The Substantially All Test was particularly relevant to any service partner seeking to monetize its API in a fund that primarily holds capital assets for less than 3 years.
With respect to determining the partner’s holding period on a taxable disposition of an API, the Final Regulations remove the Substantially All Test and limit the “look-through” requirement to situations in which, at the time of disposition of an API held for more than 3 years,
(1) the API would have a holding period of 3 years or less if the holding period of such API were determined by not including any period prior to the date that an unrelated nonservice 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).
In addition, the Final Regulations confirm that long-term capital gain from the disposition of “distributed API property” that, if sold by the partnership, would not be recharacterized under section 1061(a), such as Section 1231 or Section 1256 gain, qualified dividends described in Section 1(h)(11)(B), and any other capital gain that is characterized as long-term or short-term without regard to the holding period rules in Section 1222.
Transfers to Related Parties
The Final Regulations confirm that Section 1061(d) does not accelerate gain with respect to all transfers to related parties. They further provide that the amount that may be recharacterized includes only long-term gain that the partner recognizes upon a transfer through a taxable sale or exchange of an API to certain related parties.
Elimination of Transition Rule
The Proposed Regulations provided a transition rule pursuant to which eligible funds could irrevocably elect to exclude long-term capital gains and losses of certain property held by the fund from recharacterization under Section 1061. The transition rule applied 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 fund that was in existence as of Jan. 1, 2018.
The Final Regulations eliminate the ability of a fund that was in existence as of January 1, 2018, to make the transition rule election as it was deemed unnecessary given the operation of the Final Regulations.
Profits Interest Waivers
The Preamble to the Proposed Regulations indicated that the Treasury was aware of arrangements employed by service partners to waive allocations of gain from a fund that would be subject to Section 1061, in order to be allocate future gain that could satisfy Section 1061’s 3-year holding period. The Preamble to the Proposed Regulations included a warning that such arrangements may be subject to challenge on various grounds and should comply with generally applicable tax laws, including those that also apply to so-called “management fee waivers” (see client alert on management fee waivers”). The Final Regulations (including its Preamble) are completely silent on profits interest waiver arrangements. Nevertheless, careful planning should continue to be used when implementing such arrangements.
We will continue to monitor this developing issue. Meanwhile, if you have any questions on the Final Regulations, or implementation of Section 1061 , please contact Bradley Wooldridge or your Manning Fulton relationship attorney.