Carried Interest Tax Treatment: IRS Issues Proposed Regulations Under Section 1061
By Alexander DeRienzo and Joel Unger
August 20, 2020
On July 31, the IRS and Treasury Department provided guidance on the treatment of “carried interest” by issuing proposed regulations under Internal Revenue Code (“IRC”) §1061. The majority of the proposed regulations will be effective for tax years beginning after the final regulations are published, but may be relied upon before that time if they are followed in a complete and consistent manner.
Section 1061 – Background
Congress enacted §1061 as part of the Tax Cuts and Jobs Act (“TCJA”) in 2017. The provision calls for an increase to three years from the current one year holding period to receive favorable long-term capital gains treatment on the sale of assets derived from holding an “applicable partnership interest” (“API”).
Fund managers receiving carried interest and gains related to holding a profits interest for the performance of certain services are subject to §1061 and the extended holding period. Failure to satisfy the requirements could result in taxpayers being subject to the top ordinary tax rate of 37%, plus the 3.8% net investment income tax (“NIIT”), if applicable.
The proposed regulations have generally satisfied the questions and uncertainty that were raised by tax practitioners since the issuance of §1061.
- The proposed regulations confirmed that “net long-term capital gains” only include capital gains as defined in IRC §1222. This is a welcome exclusion of §1231 gains from the sale of business property, §1256 gains from contracts and straddles, and qualified dividends.
- The “corporation exception” vaguely defined by §1061 does not apply to S Corporations or Passive Foreign Investment Companies (“PFIC”) for which a Qualified Electing Fund (“QEF”) election was made. Therefore, these entities are subject to the holding period under §1061.
- It was emphasized that once a partnership interest qualifies as an API, it remains an API, unless an exception is met. This is the case regardless of whether an API is transferred, gifted, or disposed of.
- If an API is owned through a tiered-partnership then the API retains it character through the tiered-partnership structure and would need to be treated consistently at each tier.
- Funds cannot avoid §1061 by distributing property. Property distributed by a partnership in connection to an API retains its character in the hands of the recipient. The three-year holding period would need to be met by the partnership, partner, or the aggregation of both to receive long-term capital gains treatment when the property is ultimately sold.
- Transfers of an API to a related party could lead to several unintended consequences. For example, a short term gain could be triggered on the transfer of an API to a related party if the assets had a holding period of 3 years or less. Additionally, if an API was transferred in any otherwise non-taxable transfer (i.e. gifted) that could trigger a short-term gain as well.
Fund Managers and Private Equity Companies will need to consider the new proposed regulations under §1061 to ensure that many of the common structures used for Carried Interest Partners such as tiered partnerships, PFIC’s, and S-Corporations comply with the three-year holding period.
Exceptions to Section 1061
- An exception to the three-year holding period is available for a capital interest funded by cash or property. Funding derived from related party debt may not meet this exception.
- An unrelated third party who purchases an API at fair market value would not be subject to §1061 to the extent that they are not expected to become a service provider to the partnership.
To avoid the tax consequences of §1061, some funds have amended their partnership agreements to allow managers using carry waivers, which allow an API holder to forego their allocation rights on assets that would be classified as short-term capital assets in favor of allocations from long-term capital assets. The proposed regulations do not specifically reject these types of arrangements but do state they could be challenged under IRS examination.
Passthrough entities generating gains subject to §1061 will be required to disclose the necessary information for taxpayers to accurately categorize their gains. This requirement also applies to tiered partnerships that hold an interest in a lower tier that passes through §1061 information.
The proposed regulations have not given clear guidelines for reporting other than the requirement to provide the taxpayer with the relevant information to determine the different categories of gain under §1061. Future guidance will be needed to determine if additional forms or specific disclosures would be required.
Please contact your Mazars USA LLP professional for additional information.