Carried Interest Regulations and the Future of a Debated Tax Break

  • Tax Reform
  • 3/2/2021
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While the future of carried interest and long-term capital gain tax rates may remain in flux, we do have clarity on required holding periods. Review new regulations ...

Key insights

  • The IRS issued final regulations under Section 1061 that provide much-needed clarity on carried interests.
  • The required holding period for carried interests to achieve long-term capital gain tax rates has been expanded from one to three years.
  • Partners may only need their partnerships to meet this holding period requirement in order to benefit.
  • The recent political shift may prioritize the dismantling of any remaining carried interest tax break.

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On January 7, 2021, the Department of the Treasury and the IRS issued final regulations under Section 1061 of the Internal Revenue Code regarding the taxation of carried interests. These rules make some notable (and mostly taxpayer-friendly) changes to regulations proposed in July 2020. For calendar year taxpayers, the rules generally take effect January 1, 2022, although taxpayers may opt to follow the regulations now.

Section 1061 presents a complex and far-reaching framework that fund managers should consider as they structure or dispose of carried interests. There remains, however, an element of uncertainty, as the preferential tax treatment for carried interests could be eliminated with the shift in political power following the election. Although COVID-19 relief remains top of mind for Congress and the Biden administration, additional changes to carried interests could be on the horizon.

Background of Section 1061

Carried interests, an essential aspect of investment funds, serve as an incentive for managers to improve the performance of their funds’ assets — the better a fund performs, the more proceeds go to the fund managers. Under current tax rules, carried interests qualify for preferential capital gains rates, though many have argued that they should be taxed at ordinary rates since they are akin to a bonus for services performed by the holder.

Enacted as part of the 2017 Tax Cuts and Jobs Act, Section 1061 was the first step taken to curtail the preferential treatment of carried interests. The key change established in Section 1061 is that carried interests must be held for three years (rather than the normal one-year period) to qualify for long-term capital gains treatment. While simple in concept, the new legislation is anything but straightforward.

Basic framework of Section 1061

An interest that is subject to Section 1061 — and thus subject to recharacterization as short-term capital gain — is called an “applicable partnership interest” (API). This is generally defined as an interest in a partnership held by a taxpayer in connection with the performance of substantial services if the partnership is an “applicable trade or business” (ATB).

An ATB is defined as any activity conducted on a regular, continuous, and substantial basis, through one or more entities, that consists of:

  1. Raising or returning capital, and
  2. Investing in, disposing of, identifying, or developing specified assets

The term “specified assets” encompasses securities, commodities, or real estate held for rental or investment, cash or cash equivalents, options or derivatives, and contracts with respect to any of these. The term also covers an interest in a partnership to the extent of its proportionate interest in any of the aforementioned asset types.

Proposed and final regulations

The proposed regulations provided some much-needed clarity regarding the application and administration of Section 1061, but certain questions remained unanswered until the final regulations were issued. Below is an outline of salient points from both sets of regulations.

API status does not change

Once an interest is classified as an API, it remains one even if the partner holding the API ceases to perform services for the partnership. However, certain transfers may cleanse an interest’s API status.

Recharacterization amount

The amount that is treated as short-term capital gain is called the “recharacterization amount,” which requires netting of the partner’s one-year and three-year gain amounts.

Relevant holding period

A partnership’s holding period of an asset is generally determinative when analyzing the recharacterization amount under Section 1061, not the partner’s holding period of their interest. For example, if a partnership sells an asset held for five years, but one of its partners held their interest for only two years, the partner will still meet the three-year holding requirement. However, partners’ holding periods are still relevant for determining the characterization of gain resulting from the disposition of their interests.

The holding period rules are important to keep in mind when structuring sale transactions. For example, if a service partner sells a partnership interest held for less than three years, the sale of the interest may be subject to the carried interest rules. If the partnership held the underlying assets for more than three years, the sale of assets would not be subject to the carried interest rules. Even if a partnership interest has been held for more than three years the sale could be subject to the carried interest rules under an anti-abuse rule added in the final regulations.

Applicable gains and the real estate carveout

Not all gains are covered by Section 1061. Only gains from the sale of capital assets under Section 1222 are subject to recharacterization. Most notably, Section 1061 does not apply to Section 1231 gains. Section 1231 generally applies to real or depreciable property used in a trade or business that is held for more than one year — it also means net gains qualify as long-term capital gains while such net losses are treated as ordinary losses.

The Section 1231 exception offers a substantial benefit for real estate investment partnerships whereby the sponsors’ carried interests — commonly referred to as “promotes” — can avoid recharacterization under Section 1061 (with some limitations, such as vacant land held for investment).

Mark-to-market gains under Section 1256 (e.g., futures contracts, foreign currency contracts), as well as qualified dividend income, are also exempt from recharacterization.

Capital interest exception

Section 1061 provides an exception for capital interests that give the holder the right to share in partnership capital commensurate with the amount of capital contributed or the value of the interest subject to tax under Section 83. The proposed regulations stated that the capital interest exception applied to allocations of a partner’s capital only if they were made in the “same manner” as allocations made to unrelated nonservice partners with a significant aggregate capital account balance (defined as at least 5%).

The unclear language in the proposed regulations seemed unworkable in certain circumstances, including instances where partnerships use targeted allocations instead of allocations in accordance with capital account balances. The final regulations provide greater clarity and flexibility, replacing the “same manner” language with a “similar manner” test, under which a fund manager’s capital interest rights must be “reasonably consistent” with the rights of the fund’s limited partners. Additionally, the final regulations clarify that recognized API gains that are reinvested in a fund may qualify for the capital interest exception for purposes of future allocations and distributions.

Corporate exception

A partnership interest held by a corporation is not an API. Based on the language of Section 1061, taxpayers quickly found an apparent workaround to avoid recharacterization through the use of S corporations. However, the IRS issued guidance in 2018 indicating that the definition of “corporation” under Section 1061 excluded S corporations, and the proposed regulations ultimately codified this exception. Thus, the corporation exception has been narrowed to only include interests held by C corporations.

Transfers of APIs

As mentioned above, once an interest is an API, it remains an API. The proposed regulations provided an exception to this rule in the case of a bona fide purchase by an unrelated taxpayer that has not — and does not intend to — provide services to the partnership.

On the other hand, transfers to a related person may result in gain to the transferring API holder (which is subject to Section 1061). The proposed regulations broadly defined “transfer” in this case, and otherwise nontaxable transfers would be subject to the new regulations. Such a broad definition caused concern that tax-free strategies routinely used in gift and estate planning would now trigger short-term capital gain.

But the final regulations narrow this application and explain that recharacterization only applies where the transfer is a taxable transaction. As such, nontaxable transfers (e.g., gifts) would not create an API gain, although taxable gains triggered subsequent to the transfer would still be subject to recharacterization.

Definition of taxpayer and netting of APIs

The proposed regulations established a hybrid approach to identify the relevant taxpayer under Section 1061. Each pass-through entity in a structure must separately track and report their share of API gains and losses — but the individual taxpayers receiving the API gains and losses must net all such amounts in order to determine their recharacterization amount. This hybrid approach seems to strike a reasonable balance between the administrative task of API tracking at the partnership level and passing through the ultimate tax burden to individual fund managers.

Carry waivers

After Section 1061 was codified, fund managers explored using carried interest waivers to potentially sidestep recharacterization, despite the preamble to the proposed regulations having warned taxpayers that such a practice could be challenged on various grounds. Interestingly, the final regulations are silent on this point. Given the clear warning in the proposed rules though, exercise caution if you’re considering a possible carry waiver.

Impacts to funds and their managers

Funds and their managers should consider the impacts of Section 1061 and the new regulations, but these repercussions differ depending upon the fund type. As one example, traditional private equity buyout funds may not be heavily affected, as they tend to hold their portfolio companies beyond the required three-year period. On the other hand, hedge funds may be significantly impacted due to the shorter holding periods that are common for their assets. Additionally, Section 1061 may bring administrative complexity as funds track and report APIs for their general partners.

An uncertain future for carried interests

With all of this said, the future of carried interest taxation may be in question. For decades, carries have been a major point of contention among lawmakers. While Section 1061 sought to curb the existing favorable treatment, many in Congress seek a complete elimination of the tax-preferred treatment that carried interests have long enjoyed.

Democratic Senator Ron Wyden proposed legislation in 2019 that would have taxed all carried interests — irrespective of holding period — as compensation income subject to self-employment tax. Although the bill did not advance in Congress at the time, Senator Wyden, who is now chair of the Senate Finance Committee, may renew his plan to end this tax break.

The combination of a slim margin that favors Democrats in Congress and broad support within the party to raise taxes on high earners increases the possibility that carried interests could face a overhaul in the near future. In the meantime, review the current impacts of Section 1061 with a trusted advisor.

How we can help

CLA works with funds and their sponsors across all facets of the investment lifecycle, from capital raising to tax compliance. Our private equity and real estate professionals have the knowledge and experience to guide clients through the challenging landscape of fund formation, operations, exits, and dissolution.

We’re positioned to help you assess and comply with the new carried interest tax rules while seamlessly integrating with your fund’s operations. Contact us to understand how these important developments apply to your organization.

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