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Davis Polk Discusses IRS Proposal on Carried Interest Regulations

On July 31, the IRS and Treasury proposed regulations (the “Carried Interest Regulations”) on the taxation of carried interest under Section 1061 of the tax code.  Section 1061 was added to the tax code as part of the 2017 tax reform legislation and generally provides that capital gain allocated under certain carried interest arrangements is eligible for the favorable 20% U.S. federal income tax rate only if the underlying asset was held for more than three years at the time of sale.

The Carried Interest Regulations are, on the whole, consistent in most respects with the manner in which most taxpayers have been applying Section 1061 since its enactment.  However, while Section 1061 includes a statutory exception for capital gain attributable to a sponsor’s own capital interest, the Carried Interest Regulations take a surprisingly narrow view on when this exception is available. Further, the Carried Interest Regulations include a variety of rules designed to prevent taxpayers from avoiding the application of Section 1061, including rules relating to distributions of property that has a holding period of three years or less and rules relating to the sale (directly or indirectly) of a partnership interest that is subject to Section 1061.

While the Carried Interest Regulations will generally be effective for taxable years beginning after the final regulations are published, taxpayers are permitted to rely on the Carried Interest Regulations before that time so long as they follow them in their entirety and in a consistent manner.

Partnership Interests Covered by Section 1061

Section 1061 applies to a partnership interest (an “applicable partnership interest” or “API”) which is directly or indirectly transferred to or held by a taxpayer in connection with the performance of substantial services by the taxpayer (or a related person) in an “applicable trade or business.”  An applicable trade or business (referred to below as a “Fund Business”) is generally defined in the Carried Interest Regulations as a trade or business that consists in whole or in part of (i) raising or returning capital and (ii) investing or developing “specified assets” (generally including securities, commodities, real estate held for rental or investment, and certain derivatives).

Exceptions to Section 1061

Section 1061, as clarified by the Carried Interest Regulations, provides five exceptions to the definition of API:

Application of the Three-Year Holding Period to Income from Investments

The Carried Interest Regulations clarify the application of the three-year holding period requirement in several respects:

Capital Interest Gains and Losses Not Subject to Section 1061

As discussed above, Section 1061 does not apply to gain derived by the taxpayer with respect to its capital interest in the partnership.  The Carried Interest Regulations implement this exception through a complex set of computations to determine the taxpayer’s “Capital Interest Gains and Losses,” which are not subject to the three-year holding period requirement.  Unfortunately, given the manner in which many private investment funds operate, the framework for determining this amount set forth in the Carried Interest Regulations may cause a significant amount of gain attributable to capital contributions[2] to be subject to the three-year holding period requirement.

Under the Carried Interest Regulations, an API holder’s “Capital Interest Gains and Losses” are gains and losses attributable to “Capital Interest Allocations,” or allocations of long-term capital gain and loss from the underlying partnership (or tiers of partnerships) meeting the following requirements:

Allocations are considered to be made in the same manner if the allocations are based on the relative “book” capital accounts of the partners and the terms, priority, type and the level of risk, rate of return, and rights to cash or property distributions during the partnership’s operations and on liquidation are the same. However, there are many common situations where capital-based allocations will not meet the requirements set forth in the Carried Interest Regulations. For example:

The Carried Interest Regulations clarify that an allocation to an API holder will not fail to qualify solely because the allocation is subordinated to allocations made to unrelated non-service partners or it is not reduced by the cost of services provided by the API holder (e.g., management fees). However, the Carried Interest Regulations do not address the effect of other common differences between the capital interests of API holders and the capital interests of non-service partners, such as withdrawal rights and terms, liquidity terms, rights to tax distributions, special allocations of expenses other than management fees and the fact that API holders’ capital allocations are not subject to carried interest or incentive allocations.

The Carried Interest Regulations also provide that unrealized gains in respect of an API cannot be converted into gains attributable to a “capital interest” through a recapitalization or contribution.  However, although not entirely clear on this point, the Carried Interest Regulations appear to exclude from the scope of Section 1061 any allocations of gain that are attributable to appreciation of the fund’s investments arising after such a recapitalization, so long as the gain is allocated in accordance with the rules for Capital Interest Allocations described above.

Sale of APIs

Sales to Third Party Buyers

Under the Carried Interest Regulations, in the event of a sale of an API to a third party buyer, the seller’s holding period in the API for purposes of Section 1061 is generally the holding period of the API (rather than the holding period of the underlying partnership assets).  Accordingly, a taxpayer who sells an API will be eligible for the favorable 20% federal income tax rate if the taxpayer’s holding period in the API is more than three years but will not be eligible for this favorable rate if the taxpayer’s holding period in the API is three years or less.  However, the Carried Interest Regulations provide two situations where gain otherwise meeting the three-year holding period requirement must be tested by looking at a different holding period:

Acceleration of Short-Term Gain in Sales to Family Members or Colleagues

Section 1061(d) generally triggers short-term capital gain to a taxpayer who (directly or indirectly) transfers an API to (i) a family member (as determined under certain attribution rules), (ii) a person who has performed services to the relevant Fund Business within the current calendar year or the preceding three calendar years, or (iii) a pass-through entity to the extent a person described above directly or indirectly owns an interest.  The amount of short-term capital gain is equal to the excess of (1) the net long-term capital gain from assets held for three years or less that would have been allocated to the transferor partner upon a hypothetical liquidation of the partnership, over (2) any amount treated as short-term capital gain under Section 1061.  The Carried Interest Regulations would require gain to be recognized on such a transfer even if the transaction is not otherwise taxable, but clarify that this special rule does not apply upon a contribution of the API to another partnership.

Carried Interest Waivers and Deferrals

Many fund sponsors include provisions in their funds’ partnership agreements that permit the general partner to waive or defer capital gains from investments that do not meet the three-year holding period requirement, and receive “make-up” allocations of long-term capital gains from future profits derived by the fund (so-called “carried interest waivers”). If properly structured, these arrangements can have the effect of allocating gains that would otherwise be subject to the higher tax rate applicable to short-term capital gains under Section 1061 to the fund investors (who are not subject to Section 1061), and instead allocating more-than-three-year gains to the sponsor, who holds an API and is subject to Section 1061. Although the Carried Interest Regulations do not address carried interest waivers, the preamble to the Carried Interest Regulations states that such arrangements may be subject to challenge under other provisions of existing law.

Increased Compliance Burdens

Not surprisingly, given the complexity of the Section 1061 regime, the Carried Interest Regulations impose significant additional reporting requirements on partnerships that have issued APIs and other investment entities.  Because the “owner taxpayers” must comply with Section 1061 on their individual returns, private investment funds will be required to implement new systems to track more-than-three-year gains, three-year-or-less gains, “capital interest” gains and losses and other items.  The failure to report these items will be subject to penalties.


[1] Notice 2018-18, 2018-12 I.R.B. 443

[2] As discussed above, under the Carried Interest Regulations, capital interests would not include interests attributable to capital contributions that were funded with amounts borrowed from or guaranteed by another partner, the partnership or related parties.

This post comes to us from Davis Polk & Wardwell LLP. It is based on the firm’s memorandum, “IRS Proposes Carried Interest Regulations,” dated August 3, 2020, and available here.

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