On July 31, 2020, the IRS proposed regulations to govern the “carried interest” rules – a 3-year capital gains holding period in some cases -- that were added to the tax code in 2017 to address certain perceived problems. The statutory provision is section 1061 of the Code and took effect in 2018. The proposed regulations are generally not effective until they are issued in final form – which may not happen for a while. A few provisions are effective immediately and certain provisions may be relied upon now, at the election of the taxpayer.
The proposed regulations address a number of open questions relating to section 1061, and provide detailed rules regarding computations and new schedule K-1 reporting requirements.
There are few surprises in the substantive positions taken in the proposed regulations. The following are the highlights we have observed after reviewing them for a few hours.
Section 1061 requires the recharacterization of certain long-term capital gains to short-term capital gains when allocated to taxpayers that hold, directly or indirectly, an applicable partnership interest (API)—the section 1061 term for what is commonly referred to as a ‘carried interest’. An API is any interest in a partnership held in connection with the performance of substantial services by the taxpayer in an applicable trade or business (generally, the business of providing investment management services to investment funds). Generally, long-term capital gains with respect to an API are subject to recharacterization to short-term capital gains when sourced from assets with a holding period of less than three years.
Notably, certain transfers of an API that would have otherwise been nontaxable (for example, transfers resulting from a gift or death of a partner), are no longer tax-free under the proposed regulations. Instead, if an API is transferred to a related party, in whatever manner, the taxpayer looks to the hypothetical gain the taxpayer would be allocated if the partnership were to sell all its assets in a hypothetical sale at fair market value. If any of this hypothetical gain is related to assets held for less than three years, the portion of that gain would be taxable immediately, as short-term capital gain. As carried interest gifting is a common wealth transfer strategy, the impact of this proposed provision cannot be understated.
Also of significant interest is a proposed change to the partnership holding period rules generally. Under Reg. section 1.1233-3(c)(1), when an additional interest in a partnership is acquired by a partner already holding an interest in the partnership, the holding period is bifurcated between the interests based on the relative fair market values of the interests at the time the new interest is acquired. Uncertainty exists, however, in the case of an acquisition of a profits interest, which is considered to have no value for certain purposes. The proposed regulations, however, describe a different treatment: the fair market value of the profits interest would instead be tested at the time the interest is disposed, and therefore, any interests granted within three years of disposition would result in a bifurcated holding period, and potentially additional gain subject to the recharacterization rule. The application of this rule would not be limited just to section 1061, either; it would also affect the treatment of partnership interests subject to the regular one-year holding period requirement.
The proposed regulations also confirm the tax community’s prior understanding of the treatment of several items. For instance, section 1231 and section 1256 gains (and losses) are not taken into account when determining gains/(losses) subject to the recharacterization rules in the proposed regulations, as they do not depend on the holding period referenced in section 10611. Additionally, S corporations that hold an API are subject to the recharacterization rules, as previously described in Notice 2018-18, notwithstanding the statutory language that section 1061 does not apply to an API held by a corporation. Lastly, the regulations confirm that the relevant holding period for determining which gains/(losses) are subject to the recharacterization rule is the holding period of the asset actually being sold. For example, if a taxpayer has held an API for two years and is allocated long-term capital gain from the partnership in which the API is held, related to an asset that had a holding period four years in the hands of the partnership, the recharacterization rule would not apply. Although this is the general rule, in certain instances, a taxpayer may be required to look through to the partnership’s assets.
The proposed regulations provide additional guidance, including, but not limited to, the following items:
- General computational rules for implementing the provisions of section 1061.
- Transition rules for pre-2018 gains, including pre-2018 installment sale gains.
- Rules regarding the definition of an applicable trade or business, including a requirement to consider all relevant business activities in the aggregate
- Partnership reporting requirements for various section 1061 items when a partner holds an API
The proposed regulations would become effective for taxable years beginning on or after the date final regulations are published in the Federal Register, meaning they would not be effective for calendar year taxpayers until, at the earliest, calendar year 2021. Taxpayers may rely on the proposed regulations for taxable years beginning before the date final regulations are published in the Federal Register, provided they follow the proposed regulations in their entirety and in a consistent manner2. In any case, taxpayers potentially affected by the section 1061 recharacterization rule should consult with their tax advisors on the impact of these proposed regulations on both current and prior period tax returns.
1That of section 1222(3) and (4)
2Taxpayer may, however, rely on a transition rule for assets held for at least three years as December 31, 2017, without having to follow the entirety of the proposed regulations