01.29.2021 IRS Releases Finalized Regulations Regarding Taxation of Carried Interest
The U.S. Department of Treasury and the Internal Revenue Service recently issued final regulations (“the Final Regulations”) regarding certain aspects of so-called carried interest under Section 1061 of the Internal Revenue Code, which applies to “applicable partnership interests” (an “API”). Some of the more pertinent rules set forth in the Final Regulations include the following:
- Once a partnership interest qualifies as an API, it remains an API unless and until an exception within the Final Regulations applies to such interest.
- In addition to the statutory exceptions to the carried interest rules, the Final Regulations add another exception for the purchase of an interest in a bona fide sale to an unrelated taxpayer.
- The statutory exception to the carried interest rules for corporations excludes S corporations. This means that S corporations are included within the definition of passthrough entities and are subject to the carried interest rules under Code Section 1061.
- Special rules apply to REIT capital gain dividends. The look-through rules applying to REITs also apply to regulated investment companies.
Code Section 1061 and Relevant Definitions
Code Section 1061, added as part of the 2017 Tax Cuts and Jobs Act, addresses the taxation of an API, or so-called “carried interest.” Under the rules, certain long-term capital gain is recharacterized as short-term capital gain when allocated to a taxpayer that holds an API, directly or indirectly. The result of the recharacterization means that such capital gains are taxed generally at ordinary income tax rates.
In general, an API is an interest in a partnership that, directly or indirectly, is transferred to (or held by) a taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in a regular, continuous, and substantial activity (generally applying principles under Code Section 162) consisting of raising or returning capital, and either investing in or developing securities, commodities, real estate, or partnership interests (i.e., an “applicable trade or business” or “ATB”).
Under the Final Regulations, a taxpayer is presumed to be engaged in providing “substantial services” to the extent that such taxpayer receives a partnership interest in connection with the performance of services by the taxpayer or a related person. Related parties are those parties who would be related under Code Sections 707(b) and 267(b).
Importantly, once a partnership is classified as an API, it remains an API, even if the individual or entity holding the API ceases to provide services, or the API is contributed or distributed from another partnership.
Exceptions to an API
Section 1061 of the Code provides four exceptions to the carried interest rules, and the Final Regulations include one more:
1. Exception for interest granted for services exclusively provided to one entity;
2. Exception for corporations;
3. Exception for capital interests; and
4. Exception (added under the Final Regulations) for a bona fide purchaser.
Exception for Corporations
The Code provides that the term API does not include any partnership interest held directly or indirectly by a corporation.
Consistent with additional guidance issued by the IRS in 2018, the Final Regulations specifically exclude S corporations from the definition of a corporation. The exclusion applies to taxable years beginning after December 31, 2017.
Exception for Capital Interests
Under the Code, an API also does not include “any capital interest in the partnership which provides the taxpayer with a right to share in partnership capital commensurate with (i) the amount of capital contributed (determined at the time of receipt of such partnership interest), or (ii) the value of the interest subject to tax under Section 83 of the Code upon receipt or vesting of such interest.”
The Final Regulations provide that allocations will be considered to be commensurate with capital contributed if the allocation is made in a similar manner to the API holder with respect to its capital interest as they are to another significant, unrelated, and non-service providing partners who have made significant aggregate capital contributions (at least 5% or more of the aggregate capital contributed to the partnership). The determination of “in a similar manner” shall be based on whether allocation and distribution rights are consistent with those of an unrelated non-service partner. A non-exclusive list of relevant factors to make the “similar manner” determination for capital contributed includes the amount and timing, rate of return, terms, priority, type and level of risk, and rights to cash or property distributions during the operations and on liquidation.
The Final Regulations also provide that an interest in a fund made by a loan or advance, may qualify for the exception subject to certain requirements, including that the loan is fully recourse to the service provider, the service provider has no right to reimbursement from any other person, and the loan is not guaranteed by any other person.
Exception for a Bona Fide Purchaser
The Final Regulations include an additional exception to the carried interest rules for a bona fide purchaser.
That is, if an API is transferred in a bona fide sale at fair market value to an unrelated person (who is also unrelated to any service provider, and who has not provided and has no intention of providing services; and is unrelated), the purchaser will not be treated as acquiring an API upon such sale.
Exclusion of Certain Capital Gain
The Final Regulations confirm that items that are treated as capital gain without regard to the holding period requirements of Code Sections 1222 are excluded from Code Section 1061, and are not, therefore, subject to recharacterization. These capital gains include so-called Section 1231 gains, qualified dividend income, and Section 1256 marked-to-market capital gain.
Note that the exclusion of Section 1231 gains from recharacterization may limit the impact of these finalized rules to real estate partnerships. Code Section 1231 provides long-term capital gain treatment to depreciable property and real property, including rental property, used in a trade or business for greater than a year. Thus, this exclusion would apply for the direct sale of Section 1231 property. An indirect sale, transferring ownership of the property through a partnership interest, remains subject to potential recharacterization if the longer holding period is not met.
Relevant Holding Period: Holding Period in API or the Assets
The Final Regulations confirm that the applicable holding period for purposes of Section 1061 is the direct owner’s holding period of the asset being sold. Thus, if a partnership disposes of an asset, it is the partnership’s holding period of the asset that controls for purposes of Section 1061, rather than a partner’s holding period of his, her, or its API. Presumably then, this rule would apply even if a partner held the API for less than three years but receives an allocation associated with an asset sold having a holding period that exceeds the three-year holding period requirement.
A taxpayer’s holding period in its API would generally be relevant if the API itself is sold directly. A look-through rule will apply in certain situations, where either: (1) the API’s holding period would be three years or less if determined by excluding any period prior to unrelated non-service partners being legally obligated to contribute substantial money or property (at least 5% of the partnership’s total capital contribution as of the time of the API disposition), or (2) a transaction or series of transactions have taken place with a principal purpose of avoiding gain recharacterization under Section 1061(a). The Final Regulations remove the broader look-through rule from the Proposed Regulations, released in August 2020, which had included a substantially-all test.
Transfers to Related Persons
Section 1061 provides that a transfer by a taxpayer of an API, directly or indirectly, to a related person is a gain recharacterization event. The Final Regulations confirm this treatment, limiting the definition of a transfer to “a sale or exchange in which gain is recognized.” The Final Regulations thus narrow the scope from the Proposed Regulations, which had included contributions, distributions, or gifts as transfers, and triggered gain recognition regardless of whether such gain would otherwise be recognized.
“Related persons” are defined under the Final Regulations as: members of the taxpayer’s family (within the meaning of Code Section 318(a)); a person that performed a service within the current calendar year or the preceding three calendar years in any ATB in which or for which the taxpayer performed services; or any passthrough entity in which a person meeting either preceding definition owns an interest.
To the extent designated by a REIT, the Final Regulations will allow for long term capital gain treatment on capital gain dividends when such dividends result from assets held for longer than three years. While the disclosure of supporting documentation is not required, REITs not making the disclosure will apply short term gain rates to the entire amount of the gain subject to API rules. Taxpayers with API losses from REIT shares held for six months or less with capital gain distributed by the REIT not disclosed as a three-year amount will be subjected to short term capital gain rates.
The Final Regulations have been published in the Federal Register and are effective as of January 13, 2021. The rules excluding S corporations from the API exception are effective for taxable years beginning after December 31, 2017.
Taxpayers should review their existing and future operating and limited partnership agreements and structures that may be impacted by the Final Regulations. Please contact the authors of this article if you have any questions on the effects to your business.