Proposed regulations issued on carried interest rules

| 8/27/2020
Proposed regulations issued on carried interest rules
On Aug. 14, the U.S. Department of the Treasury and the IRS issued proposed regulations under IRC Section 1061, which limits the preferential long-term capital gain tax treatment of partnership profit interests (sometimes referred to as carried interests) held by investment fund managers. Enacted as part of the Tax Cuts and Jobs Act of 2017, and effective for tax years beginning after Dec. 31, 2017, IRC Section 1061 generally recharacterizes net long-term capital gains as short-term capital gains on the disposition of an applicable partnership interest (API). IRC Section 1061(c) defines an API as a partnership interest held by, or transferred to, a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or by any other related person, in any applicable trade or business. Excluded from this definition are interests held directly or indirectly by a corporation and certain capital interests in a partnership that are based on capital contributed or the value of the interest under IRC Section 83.
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Following are highlights of the proposed regulations:

  • Applicable partnership interest. The proposed regulations broadly construe API to generally include all carried interests held directly or indirectly through a partnership, an S corporation, or a passive foreign investment company with respect to which a qualified electing fund (QEF) election is in effect. The issuance of proposed regulations also has narrowed the exceptions to the definition of API. For instance, the exception for corporations is limited to interest held by C corporations but not by S corporations. In addition, the definition of API does not include certain capital interests or partnership interests held by employees of entities not engaged in an investment advisory business. The exclusion of the capital interests from the definition of API is likely to create further complexity for funds that do not subject all partners to the same fee and carry provisions.
  • Holding period. The three-year holding period is determined by reference to the owner of the asset that is sold regardless of whether the asset is the API held directly by the ultimate taxpayer or an asset held by an entity in which the taxpayer has an API (including lower-tier partnerships and assets held by lower-tier partnerships).
  • Look-through rule. The proposed regulations apply a look-through rule for the direct or indirect sale of an API with a holding period exceeding three years if one of two circumstances apply:
    • If at least 80% of the assets of the entity in which the API is held are capital assets that, if disposed of, would be treated as held for three years or less
    • In certain tiered partnership situations
  • Transfers to related persons. Section 1061(d) provides rules that generally treat nontaxable transfers of an API held for three years or less to a related party as taxable and subject to the rules under IRC Section 1061. The proposed regulations apply these rules to otherwise unrecognized net built-in capital gain from either the underlying assets of an entity in which an API is held or an API with a holding period of three years or less. For this purpose, a related person generally is a spouse, child, grandchild, or parent; a person who provides investment advisory services within the same calendar year as, or the three years preceding, the transfer; or a pass-through entity owned by either of the foregoing.
  • Aggregation of gains and losses. The proposed regulations aggregate gains and losses from multiple interests at the ultimate beneficial owner level before determining the amount subject to recharacterization.
  • Disapplication to certain assets. The proposed regulations clarify that IRC Section 1061 does not apply to IRC Section 1231 gains or qualified dividend income, which might be a planning opportunity for certain investment partnerships.
  • Carried interest waivers. The preamble to the proposed regulations cautions that a waiver of rights to distribution of gains from a partnership might not be effective to defeat application of IRC Section 1061 and could be challenged by the IRS.
  • Reporting requirements. The proposed regulations create a complex regime for sharing information necessary for application of rules under IRC Section 1061 through tiers of entities to the ultimate taxpayer. The proposed regulations also require taxpayers and pass-through entities within the tiers to request information when necessary. If required information is not provided by a partnership, the IRS will apply the IRC Section 1061 rules using assumptions about the missing information that likely will result in the ultimate taxpayer reporting more short-term gain than would be required if the information had been provided. Affected entities will need to review their recordkeeping and reporting procedures and update these as needed to comply with the new rules. There will be more insight into these rules once the IRS releases updated forms and instructions.
  • Effective date. The regulations are proposed to be effective for taxable years beginning on or after the date final regulations are published. However, taxpayers and partnerships generally can rely on the proposed regulations for tax years beginning before the final regulations are issued if they consistently follow the proposed regulations for tax years beginning on or after Dec. 31, 2017.

Partnership rules have become increasingly complex over the past few years. The rules under IRC Section 1061, including reporting and recordkeeping, add further complexity and burden for partnerships and their owners. Taxpayers should work with their tax advisers to identify planning opportunities to mitigate the cost of complying with these new rules.

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