Proposed Regulations Provide Guidance for TCJA’s New Carried Interest Rules
August 7, 2020
On July 31, the US Treasury Department (“Treasury”) and the IRS issued proposed regulations under Section 1061 of the Code (the “Proposed Regulations”).1 This provision, enacted as part of the Tax Cuts and Jobs Acts of 2017 (the “TCJA”), applies a new rule for determining whether the sale of a capital asset by a partnership would be long-term capital gain (LTCG) or short-term capital gain (STCG) when allocated to certain persons providing services to that partnership. Section 1061 is intended to reduce the availability of favorable LTCG tax treatment with respect to a “carried interest” in an investment fund, while allowing LTCG tax treatment under the normal rules with respect to a service provider’s allocable share of gain related to the service provider’s capital investment, if any, in the partnership.
The long-awaited Proposed Regulations provide welcome clarity to the application of Section 1061, and in particular the holding period requirement for tiered structures, the scope of the applicable income and gain subject to the three-year holding period, the treatment of secondary transactions, calculation mechanics, reporting requirements, and exceptions from Section 1061. However, the Proposed Regulations also emphasize that Treasury and the IRS will closely scrutinize mitigation strategies employed by certain investment funds to limit exposure to STCG. Taxpayers may rely upon these Proposed Regulations until final regulations are published as long they apply the Proposed Regulations in their entirety and in a consistent manner.
O’Melveny’s Key Observations
Investment managers should work closely with their advisors to assess the impact of the Proposed Regulations and whether any changes to legal agreements or internal documentation processes are needed, including the following considerations:
- We note that satisfying the exclusion from Section 1061 for Capital Interests (defined below) for purposes of the Proposed Regulations may prove challenging and will require advance planning and documentation. Investment managers that hold Capital Interests in addition to a carried interest in a fund should consider whether the fund’s partnership agreements and books and records are sufficiently detailed so as to permit a bifurcation of a manager’s Capital Interest and carried interest in compliance with the Proposed Regulations (e.g., issuing different classes of interests).
- In light of Treasury indicating that it will closely scrutinize carried interest waiver provisions, investment managers should review whether any such provision in their fund documents are properly structured. Investment managers that do not currently have the ability to waive carried interest should consider whether to revise their fund documents to include properly structured carried interest waiver provisions.
- In addition, any investment manager holding his or her carried interest through an S-corporation or a PFIC for which a QEF election has been made should prepare for an IRS challenge given the restriction imposed by the Proposed Regulations.
- Although partnership interests subject to Section 1061 generally retain such status regardless of changes in the activities of the partnership or the person(s) holding the interest, a partnership interest acquired in a secondary purchase by an unrelated third party may no longer be subject to Section 1061 in the purchaser’s hands.
- Taxpayers should review any contemplated estate or gift planning since a transfer (or gifting) of an API to related parties may cause inadvertent tax consequences, including the immediate taxation of the amount realized on the transfer.
Very generally, gain from the sale or exchange of a capital asset (e.g., stock in a corporation or a partnership interest) held for more than one year constitutes LTCG2 and is eligible for a reduced rate of federal income taxation when recognized by an individual (currently a maximum of 20% versus a maximum of 37% for ordinary income). Most other gains from the sale of capital assets are treated as STCG, which is generally taxed at the same rate as ordinary income. Individuals who are partners in a partnership that sells a capital asset it held for more than one year are generally eligible for the beneficial rate afforded to LTCG with respect to their allocable share of the partnership’s gain from the sale.
Prior to the TCJA, an investment manager holding a carried interest in an investment fund would be eligible for the beneficial LTCG tax rate on any LTCG allocated to such taxpayer in the same manner as any other partner. Section 1061, however, recharacterizes as STCG what would otherwise be LTCG allocated to a taxpayer with respect to an applicable partnership interest (API) unless the gain is attributable to the sale of capital assets held by the partnership for more than three years. As discussed below under the heading “Definition of API,” the carried interest held by most investment fund managers will generally constitute an API.
Definition of API
General Rules. An API is an interest in a partnership’s profits that is issued in connection with the performance of “substantial” services by the taxpayer (or by any related person) in an applicable trade or business (ATB) of the partnership consisting of investing in, disposing of, or developing (“Specified Actions”) certain assets (“Specified Assets”). Specified Assets means securities, commodities, real estate held for rent or investment, cash or cash equivalents, options or derivatives with respect to the foregoing, and a partnership interest to the extent of the partnership’s proportionate interest in any of the foregoing.
The Proposed Regulations further clarify that:
- The rules cannot be avoided through derivative transactions; an API includes any financial instrument or contract the value of which is determined (in whole or in part) by reference to an applicable partnership (including the amount of partnership distributions, the value of partnership assets, or the results of partnership operations).
- While a carried interest generally takes the form of a “profits interest,” not all profits interests are APIs, and not all APIs are profits interests (e.g., the contracts and financial instruments described in the previous bullet). The Proposed Regulations also provide detailed rules for calculating the amount of gain subject to recharacterization under Section 1061. Generally, Treasury and the IRS propose adopting what they refer to as a “partial entity” approach, which determines the existence of an API at the entity level, but calculates the amount of LTCG that will be recharacterized as STCG at the owner level. Thus, if an API holder owns more than one API, gain and loss from those APIs will be included in that holder’s taxable income on a net basis. The Proposed Regulations also provide guidance on the determination of the appropriate holding periods of underlying assets and the determination of the fair market value of APIs.
ATB and Specified Actions. A partnership is engaged in an ATB if it engages in Specified Actions on a regular, continuous, and substantial basis sufficient to meet the trade or business test provided in Section 162 of the Code.3 Specified Actions include those actions taken by a person related to the relevant partnership. For example, in the private equity context, if the general partner (the “GP”) entity (assuming it is treated as a partnership for US tax purposes) does not perform services for the fund directly, but instead, as is typical, performs them through a related management company, those services will be imputed to the GP for purposes of Section 1061.
The Proposed Regulations specify that the service provider does not need to participate in the ATB for the entire period in which the service provider holds the API. Once the service provider begins providing services with respect to the partnership’s ATB, a partnership interest meeting the other requirements will become an API.
In addition, although the statute requires that a service provider’s services to the partnership’s ATB must be “substantial,” the Proposed Regulations presume those services to be substantial based on the fact that the interest would only have been issued if the services were economically commensurate with the value of the partnership interest. Treasury and the IRS request comments on this presumption and the specifics of any arrangements where the presumption can be rebutted because a service provider provides insubstantial services in exchange for a profits interest.
Exceptions to the Definition of API and Gains Subject to Recharacterization
Interests Held by Corporations. The statute provides that any partnership interest held directly or indirectly by a corporation will not be treated as an API. Upon enactment of Section 1061, practitioners considered whether this exception would apply to certain entities that are corporations for US federal income tax purposes but nevertheless afford pass-through treatment to their shareholders. For example, practitioners speculated that this exception could allow S-corporations or “passive foreign investment companies” (PFICs) for which the services providers have “qualified electing fund” (QEF) elections in place4 to hold partnership interests that would otherwise be APIs in order to avoid the holding period requirements imposed by Section 1061. The IRS previously stated in Notice 2018-18, and the Proposed Regulations confirm, that an S-corporation will not be treated as a corporation for purposes of this exception. In addition, the Proposed Regulations determine that a partnership interest held through a PFIC for which a shareholder has made a QEF election is still considered API unless it falls under another applicable exception. As discussed below under the heading “Mitigation Strategies,” it is not entirely clear that Treasury has authority to modify the statutory definition of “corporation” by means of a regulation.
Capital Interests. An API holder may, in addition to the API, hold part of his or her partnership interest as a result of a capital investment in the partnership (this additional interest, a “Capital Interest”). The Proposed Regulations provide that an API holder is generally not subject to Section 1061 with respect to his or her Capital Interest if it was issued with economic terms consistent with those of third-party investors. More specifically, an API does not include a Capital Interest with economic rights commensurate with (a) the amount of capital contributed (determined at the time of receipt) or (b) the value of such interests subject to tax upon the receipt or vesting of such interest under Section 83.
Although the Proposed Regulations largely track the language of Section 1061, they also provide detailed rules for determining whether and how to allocate sale proceeds and partnership income between Capital Interests and APIs for partners holding both types of interests. For example, the Proposed Regulations provide rules for apportionment, between the partner’s Capital Interest and API, the gain or loss recognized from the sale or disposition of an upper-tier partnership interest based on a hypothetical liquidation of the upper-tier entity followed by a FMV sale of its assets and an allocation across the various interests thereafter. In order for such allocations of LTCG (without regard to Section 1061) with respect to a partner’s Capital Interests to be respected, unrelated non-service partners have an aggregate capital account balance equal to 5% or more of the aggregate capital account balances of all partners at the time the allocations are made.
Moreover, for any such allocation to be respected, the partnership agreement and the partnership’s books and records must clearly segregate the rights associated with a partner’s API and that partner’s Capital Interest. Entities that allocate carried interest among individual carry recipients should consider distinguishing Capital Interests and APIs by issuing separate classes of units for each if they do not already do so; several examples in the Proposed Regulations take this approach. If it is not possible to clearly demonstrate the portion of a gain that is allocable to a Capital Interest as opposed to an API, the IRS may not respect the partnership’s allocation to the Capital Interest and treat the entire gain as STCG allocable to the API.
Interests Held by Non-ATB Employees. A partnership interest held by a person providing services exclusively to an entity that is not an ATB of the partnership will not be treated as an API. For example, if a private equity fund’s portfolio company issues a profits interest to its own internal management team, those profits interests will typically not be treated as APIs under the Proposed Regulations.
Unrelated Third Parties. The Proposed Regulations introduce an exception not included in the statute for certain APIs purchased at fair market value by unrelated third parties in a taxable transaction. After their purchase, those APIs are not subject to Section 1061 if (a) the purchaser has not previously provided services and does not currently, and will not in the future, provide services to an ATB of the issuing partnership or a lower-tier pass-through entity, and (b) the transaction is not covered by the related party transfer rules discussed below. This exclusion is only available for secondary market purchases of APIs and does not apply to acquisition of partnership interests in a primary transaction.
Excluded Gains and Losses. Certain items of income and gain are not subject to Section 1061, including:
- Gains and losses arising under Section 1231 (relating to LTCG treatment for net gains from the sale of property used in a trade or business), “mark-to-market” gains under Section 1256 (i.e., gains from “Section 1256 contracts,” which generally include certain futures and options contracts) and qualified dividends eligible for LTCG rates;
- Distributions in kind from a partnership to an API holder if the property distributed has been held by the partnership and the distributee holder in the aggregate for more than three years will not be taxed at STCG rates. However, although the distribution does not accelerate the recognition of gain, the distributed property retains its API status and will be subject to STCG upon its disposal if it does not satisfy the three-year holding period at the time of its disposition; and
- Capital gain dividends from regulated investment companies (RICs) and real estate investment trusts (REITs) to the extent the gains are attributable to assets held for more than three years.5
Transfers of API
Related Parties. The Proposed Regulations may impose adverse consequences on an API holder’s transfer of an API to a related party. For these purposes, a related party includes the family of the taxpayer, the current and former colleagues of the taxpayer, and any pass-through entity in which one of the foregoing owns an interest. A transfer includes, but is not limited to, contributions, distributions, sales and exchanges, and gifts.
Recognition of any capital gain on a direct or indirect transfer will be accelerated upon a transfer of an API to a related party and will be LTCG and STCG based on whether the holding periods imposed by Section 1061 have been met. Related party transaction rules in their current form may create a significant trap for the unwary and taxpayers are advised to revisit any estate and gift planning transfers to consider the consequences, such as the inadvertent immediate recognition of STCG upon the transfer of interests in an otherwise non-taxable transaction and the continued API status of any transferred interests.
Unrelated Parties. An API holder will be eligible for LTCG treatment when he or she sells all or part of the API to an unrelated third party if the holder has held the API for more than three years. However, the Proposed Regulations clarify that gain from the disposition of an API to an unrelated third party will still be subject to recharacterization under Section 1061 if the following tests are not satisfied with respect to the transferred API:
- Look-through Rule for disposition of an API directly held by API Holder: If an API holder disposes of a directly held API with a holding period of more than three years, the look-through rule will apply if the assets of the partnership in which the API is held meet the Substantially All Test.
- Substantially All Test: If 80% or more of the underlying partnership assets have a holding period of three years or less, gain on the sale of an API that would otherwise be treated as LTCG will be recharacterized as STCG.
- Look-through Rule for disposition of an API held in a tiered structure: If an API holder sells at a gain an interest in an upper-tier partnership that holds a lower-tier partnership, the API holder will recognize STCG on the interest even if the API holder has held its interest in the upper-tier partnership for more than three years if either (a) the upper-tier partnership through which the API is directly or indirectly held has a holding period in the API that is less than three years or (b) the upper-tier partnership through which the API is held has a holding period in the API for more than three years and the assets of the partnership in which the API is held meet the Substantially All Test. Thus, the Proposed Regulations effectively look through the tiers of partnerships with the smaller of the holding periods controlling for purposes of determining LTCG and STCG realized on the transfer.
The Proposed Regulations provide rules regarding reporting gains with respect to an API for both the API holder and the issuing partnership, as well as the consequences of failing to properly provide the required information. The Proposed Regulations indicate that partnerships will report the necessary information on the relevant partner’s Schedule K-1.
Application of Proposed Rules
Generally, the Proposed Regulations will be effective for taxable years beginning on or after the date they are finalized. Until final regulations are adopted, taxpayers may rely on the Proposed Regulations as long as they apply them in their entirety and in a consistent manner. However, the rules in the Proposed Regulations with respect to partnership interests held by S-corporations and PFICs are effective for taxable years beginning after the date the Proposed Regulations are published.
Carry Waiver Provisions. Prior to the issuance of the Proposed Regulations, certain fund managers had begun incorporating into their fund documents an ability to waive their right to receive allocations of partnership gain to the extent that gain would not be LTCG as a result of Section 1061 (a “Waiver Provision”). The amount of gain waived could be recaptured by the carry holder with allocations of future gain earned by the fund that meet the three-year holding period requirement created by Section 1061. Generally, Waiver Provisions such as these have been drafted in such a manner as to potentially result in economic losses to the carry holder in the event the fund does not, post waiver, generate sufficient additional gain to make up for gain previously waived because practitioners expect that any Waiver Provision that does not do so could be subject to challenge by the IRS. We also note that fund agreements that allow for carry deferral at the GP’s discretion for non-tax purposes (e.g., to secure the GP clawback obligation) may strengthen the GP’s position with respect to the Waiver Provisions.
The Proposed Regulations do not include any rules that would preemptively reject Waiver Provisions. The preamble does, however, indicate that the IRS will closely scrutinize Waiver Provisions to determine whether they may cause allocations with respect to carried interest to be treated as services income under ordinary partnership allocation and anti-abuse rules and whether they may run afoul of general tax doctrines like substance over form or economic substance. The preamble thus seems to confirm that, if a Waiver Provision is to be respected, it must have real economic effect by creating some meaningful economic risk to the carried interest holders.
Corporate Holdings. While the IRS and Treasury have reiterated their position that a partnership interest held through an S-corporation or a PFIC for which a QEF election has been made does not qualify for the corporate exclusion, Section 1061, on its face, simply provides that partnership interests held by “corporations” are not APIs and does not distinguish among types of “corporations.” Although Treasury has historically been given broad deference in its ability to issue regulations, it is debatable it has the authority to limit the meaning of the word “corporation” through a regulation. Any taxpayer that attempts to bypass application of the regulations through the use of an S-corporation or a PFIC should nevertheless be prepared for an aggressive challenge by the IRS.
The Proposed Regulations provide welcome guidance to holders of APIs and partnerships that issue them, but they also limit the ability of those holders and partnerships to use planning to reduce the adverse consequences created by Section 1061. In particular, partnerships with Waiver Provisions in their partnership agreements should closely consider whether the preamble’s cautionary note raises concern with respect to their particular Waiver Provision. Treasury has requested comments regarding some outstanding issues, and the Proposed Regulations have not yet been finalized. O’Melveny will be closely monitoring further developments in this area and can assist clients with analyzing and complying with the Proposed Regulations and any future guidance related to the rules surrounding carried interest. Please contact the attorneys listed on this Client Alert or your O’Melveny counsel for questions regarding the information discussed herein.
1 All section references are to the Internal Revenue Code of 1986, as amended from time to time (the “Code”), and to the Treasury Regulations promulgated thereunder.
2 Section 1222(3) of the Code.
3 The definition of trade or business for purposes of Section 162 of the Code is beyond the scope of this discussion; a trade or business generally includes any activity carried on for the production of income conducted with continuity and regularity.
4 PFICs are foreign corporations that hold a substantial amount of passive assets and/or earn a substantial amount of passive income. U.S. shareholders in PFICs are generally subject to adverse tax consequences with respect to their shares in a PFIC. However, those shareholders often make a QEF election, which avoids these adverse tax consequences, but requires them to include their allocable share of the PFIC’s income in their own income each year. Thus, shareholders of PFICs with QEF elections in place essentially have pass-through treatment.
5 The Proposed Regulations require that the RIC or REIT provide substantial information to the API holder in order to determine the proportion of gain that it can treat as LTCG.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alexander Anderson, an O’Melveny partner licensed to practice law in New York, Alicja Biskupska-Haas, an O’Melveny partner licensed to practice law in New York, Robert Blashek, an O’Melveny partner licensed to practice law in California and New York, Robert Fisher, an O’Melveny partner licensed to practice law in California, Arthur V. Hazlitt, an O’Melveny partner licensed to practice law in New York, Tracie Ingrasin, an O’Melveny partner licensed to practice law in New York, Luc Moritz, an O’Melveny partner licensed to practice law in California, Billy Abbott, an O’Melveny counsel licensed to practice law in California and New York, Alexander Roberts, an O’Melveny counsel licensed to practice law in New York, and Dawn Lim, an O’Melveny associate licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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