How to Use the New Carried Interest Rules

August 21, 2020
Book with title New rules and regulations

The government released proposed regulations on July 31, 2020, addressing the application of code section 1061, which was added as part of the Tax Cuts and Jobs Act of 2017 and is commonly referred to as the carried interest rules.

Generally, section 1061 operates to recharacterize long-term capital gains into short-term capital gains (taxed at ordinary income rates) for certain types of partnership interests called an Applicable Partnership Interest, or API. This new code section is targeted toward managers in the private equity and hedge fund industry who, in exchange for services, often receive a percentage of a fund’s future profits (the so-called “carried interest” or “profits interest”).

What Taxpayers are Affected?
The proposed regulations provide that the new 1061 rules apply to all taxpayers holding an API, including entities that are partners in a partnership. For example, an S corporation holding a carried interest in a partnership can be subject to these proposed rules. An API is generally defined as any interest in a partnership (including an LLC classified as a partnership) transferred in connection with the performance of “substantial services” in any “applicable trade or business.

The proposed regulations define an applicable trade or business as any activity involving:

  1. Raising or returning capital, and
  2. Either investing in (or disposing of) specified assets or developing specific assets (generally securities, commodities, real estate held for rental or investment, cash or cash equivalents, and interests in other partnerships).

A taxpayer’s API does not include any interest received in exchange for a capital contribution (a capital interest). The proposed regulations introduce complex rules governing how a partnership allocates capital gains to a partner holding both an API and capital interest.

Also, an API does not include any interest held directly or indirectly by a corporation. However, for purposes of the proposed regulations, the term “corporation” does not include an S corporation.

How Does Section 1061 Work?
For taxpayers holding an API, section 1061 and the accompanying regulations recharacterize any long-term capital gain allocated to the API if the gain stems from an asset that was held by the partnership for three years or less. The allocated gain is recharacterized as short-term capital gain for the holder of the API (but not to any other partners).

Interestingly, the proposed regulations confirm the focus is on the partnership’s holding period in the capital asset, and not the partner’s holding period in its API. For instance, if a taxpayer acquires an API in a partnership in 2019, and in 2020 the partnership sells a capital asset with a holding period in excess of three years, the gain from the sale allocated to the API holder is not recharacterized, even though the API holder has only held its interest for a year. However, a partner selling its API must generally hold its API for longer than three years in order to realize long-term capital gain treatment. Even if the partner holds its interest for longer than three years, a look-through rule in the proposed regulations can recharacterize the gain from the sale of the API as short-term capital gain if 80% or more of the fair market value of the partnership’s assets consist of capital assets with a holding period of three years or less.

The proposed regulations confirm that section 1061 does not apply to section 1231 gains, because those gains are not technically from the sale of a capital asset. Section 1231 can allow taxpayers to claim capital gain treatment on any gain from the sale of business assets, but also ordinary loss treatment on any losses. The confirmation that section 1231 gains are not covered by the proposed rules is good news for real estate funds (that often generate section 1231 gains from the sale of real estate used in a trade or business) and means any section 1231 gain allocated to an API holder is not subject to re-characterization.

What Are Other Things to Consider with Section 1061?
Here are other items of interest when it comes to section 1061:

  • Certain transfers (including otherwise non-taxable transfers and gifts) of an API to a related party can trigger gain recognition.
  • Property distributed to an API holder must have been held for more than three years in total (including the partnership’s holding period in the asset) to qualify for long-term capital gains rates.
  • The proposed regulations require a partnership that has issued an API to furnish certain information to the API holder and the IRS, including the amount of capital gains and losses allocated that are subject to recharacterization.
  • The proposed rules are not effective until they are finalized, although taxpayers can rely upon the proposed regulations before they are finalized if they follow the proposed rules “in their entirety.”

How do I Take Advantage of Section 1061?
The conversion of long-term capital gains to short-term capital gains can cause a substantial increased tax burden for API holders. Careful planning may allow both a partnership and the holder of an API to avoid some of the harsh effects of these rules. Any taxpayers holding an API should consider how these new proposed rules may affect them.

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