The release of the proposed regulations provides some much needed guidance to fund managers and tax practitioners alike.

On July 31, 2020, the U.S. Treasury Department released proposed regulations to provide guidance on the application of section 1061 of the Internal Revenue Code of 1986, as amended. The proposed regulations have been particularly welcomed by managers in the private equity, venture capital and hedge fund industries, as section 1061 is particularly applicable to the taxation of carried interest.

Section 1061

The Tax Cuts and Jobs Act of 2017 enacted section 1061 of the Internal Revenue Code, which extended the long-term capital gains holding period from one year to greater than three years for any interest in a partnership that is transferred to a taxpayer in connection with the performance of services in any applicable trade or business.[1]

The Internal Revenue Code defines an “applicable trade or business” as any trade or business whose activity generally consists of (a) raising or returning capital and (b) either (i) investing in (or disposing of) specified assets or (ii) developing specified assets.[2] For purposes of section 1061, “specified assets” are defined as “securities, certain commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to the foregoing, and an interest in a partnership to the extent of the partnership’s interest in any of the foregoing.”[3]

Section 1061 further states, however, that an “applicable partnership interest” does not include, inter alia, “any interest in a partnership directly or indirectly held by a corporation” or capital interests in a partnership to the extent that (i) the taxpayer shares in partnership capital in accordance with the amount of such partner’s capital contribution or (ii) the interest is subject to tax under section 83 of the Internal Revenue Code upon its receipt or vesting schedule.[4]

As stated above, an applicable partnership interest for purposes of section 1061 generally covers the receipt of carried interest by private equity, venture capital and hedge fund managers. Its importance notwithstanding, section 1061 has proved both to be complex and ambiguous. As a result, the release of the proposed regulations provides some much needed guidance to fund managers and tax practitioners alike.

Newly Issued Proposed Regulations

The proposed regulations begin by (i) expanding the definition of an “applicable partnership interest” to include any “financial instrument or contract, the value of which is determined, in whole or in part, by reference to the partnership (including the amount of partnership distributions, the value of partnership assets, or the results of partnership operations)” and (ii) limiting the section’s applicability to only section 1222 capital gains. Items that are generally exempt from section 1061 include section 1231 gains (e.g., gains from real or depreciable business property held for more than one year), gains from section 1256 contracts and straddles (e.g., mark-to-market gains from nonequity options, foreign currency contracts, regulated futures contracts, dealer equity options and dealer securities futures contracts), qualified dividends under section 1(h)(11)(B) and certain other gains that are not determined under the holding period rules of section 1222 (e.g., gains characterized under the mixed-straddle rules).

The proposed regulations also address the use of “carried interest waivers,” which are used to circumvent the section’s three-year holding period. Similar to management fee waivers, carried interest waivers permit fund managers to waive their rights to an allocation of an investment fund’s capital gains that are realized for assets held for three years or less, while simultaneously increasing their allocable share of capital gains for assets that are held for more than three years. The proposed regulations do not bar the use of carried interest waivers, but instead specifically state that such waivers may be challenged pursuant to the existing guaranteed payment/entrepreneurial risk rules of section 707 of the Internal Revenue Code and other tools that the Internal Revenue Service has at its disposal.

Subject to the application of the "lookthrough rule" described below, with respect to the application of the three-year holding period, the proposed regulations provide that it is the holding period of the asset sold that controls the analysis. For example, if a partnership disposes of an asset, it is the partnership’s holding period in the asset that matters; conversely, if the taxpayer disposes of its applicable partnership interest, it is the holding period of such interest that matters. In other words, the taxpayer’s holding period in the applicable partnership interest is only relevant if the applicable partnership interest is being sold.

Finally, the proposed regulations also provide a limited lookthrough rule that may apply to taxpayers that dispose of an applicable partnership interest (including through tiered partnerships) with a holding period of more than three years. The proposed regulations require a taxpayer that is disposing of its applicable partnership interest with a holding period of greater than three years to look through to the assets of the underlying partnership(s) to potentially recharacterize the capital gain realized on the disposition as, in whole or in part, short-term capital gain. Specifically, the lookthrough rule will generally apply, inter alia, if “80 percent or more of the assets of the partnership in which the [applicable partnership interest] is held, based on fair market value, are assets that would produce capital gain or loss that are not [generally exempt from section 1061] if disposed of by the partnership and have a holding period of three years or less,” known as the “substantially all test.”

In the event the taxpayer is a partner in a tiered partnership structure, the lookthrough rule will apply if the applicable partnership interest has been held for more than three years and either (i) the partnership in which the taxpayer holds the applicable partnership interest has an holding period of three years or less in its own underlying applicable partnership interest or (ii) the partnership in which the taxpayer holds the applicable partnership interest has a holding period of more than three years in its underlying applicable partnership interest and the assets of such second-tier partnership meet the substantially all test.

The application of the proposed regulations are complex, particularly with respect to the three-year holding period rule and the lookthrough rule. To demonstrate the mechanics of each, we have provided the following examples:

Example 1: All Applicable Partnership Interests and Assets Are Held for More Than Three Years

P, an individual taxpayer, holds an applicable partnership interest (API) in GP, an entity taxed as a partnership. GP’s sole asset is an interest in an investment partnership (Fund), which holds one capital asset (Capital Asset). Capital Asset is not exempt from the application of section 1061. P has held its API in GP for more than three years, GP has held its interest in Fund for more than three years, and Fund has held Capital Asset for more than three years. P sells its API in GP for a $100 gain. P’s $100 gain on the sale of its API is long-term capital gain under section 1061.

Example 2: Application of the Lookthrough Rule When P Sells API with Holding Period of More Than Three Years and Fund Holds Capital Asset for Three Years or Less

Same facts as Example 1, except that Fund has held Capital Asset for three years or less. Because GP has held its interest in Fund for more than three years, P must determine whether the lookthrough rule applies to Capital Asset. The lookthrough rule will generally apply if the substantially all test applies. In this instance, since Capital Asset is not exempt from section 1061 and only has a holding period of three years or less, the lookthrough rule will apply to the sale of P’s API interest in GP. Because GP’s sole asset is its interest in Fund and because Fund’s sole asset is Capital Asset, all of P’s $100 gain on the sale of the API will be short-term capital gain under section 1061.

Example 3: API Is Held for More Than Three Years and Fund Sells Capital Asset with Holding Period of More Than Three Years

Same facts as Example 1, except that P does not sell its API in GP, and instead, Fund sells Capital Asset for $100 gain (which is ultimately all allocable to P). Because the holding period of the owner of the asset controls, P will take into account the $100 gain as long-term capital gain under section 1061.

Example 4: API Is Held for More Than Three Years and Fund Sells Capital Asset with Holding Period of Three Years or Less

Same facts as Example 3, except that Fund has only held Capital Asset for three years or less. Like above, because the holding period of the owner of the asset controls, P will take into account the $100 gain as short-term capital gain under section 1061.

Example 5: API Is Held for Three Years or Less and Fund Sells Capital Asset with Holding Period of More Than Three Years

Same facts as Example 3, except that P has only held its API in GP for three years or less. As stated in Examples 3 and 4, because the holding period of the owner of the asset controls, P will take into account the $100 gain as long-term capital gain under section 1061.

The proposed regulations will generally become effective beginning on or after the date the final regulations are published. That notwithstanding, taxpayers may generally rely on the proposed regulations prior to the date the final regulations are published.

For More Information

This Alert is not intended to be an exhaustive analysis of the tax consequences that the proposed regulations may have on taxpayers and their partnerships. If you have any questions about how the proposed regulations may specifically affect you, please contact David A. Sussman, Maximilian Viski-Hanka, any of the attorneys in our Tax Group, any of the attorneys in our Private Equity Group or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.