Final Regulations Alleviate Many Concerns About US Tax Treatment of Carried Interest, but Some Questions Remain

On January 7, 2021, Treasury released final regulations (the “Final Regulations”) under Section 1061 of the Code.¹ That provision generally recharacterizes as short-term capital gain (“STCG”) any gain allocated to a fund manager with respect to its carried interest that would otherwise be long-term capital gain (“LTCG”) if the asset giving rise to such gain was held by the fund for not more than three years. Treasury had previously proposed regulations in August 2020 (the “Proposed Regulations”), and the Final Regulations largely preserve the Proposed Regulations with some revisions and clarifications, some of which address concerns we had raised in our prior Client Alert. Nevertheless, some questions remain unanswered.

Excluded Capital Interests

The recharacterization rules of Section 1061 potentially apply to a fund manager’s carried interest that meets certain requirements noted in our prior Client Alert (an “Applicable Partnership Interest” or “API”). However, a fund manager’s interest in the fund attributable to its contributed capital (i.e., a “capital interest”) is generally not subject to the recharacterization rules of Section 1061 if that interest provides the manager with “a right to share in partnership capital commensurate with the amount of capital contributed” (an “Excluded Capital Interest”). Fund managers commonly hold both capital interests and APIs. The Proposed Regulations provided rules to distinguish Excluded Capital Interests from APIs, but as noted in the preamble to the Final Regulations, those rules failed to consider a number of common business arrangements. The Final Regulations provide rules that better align with these arrangements.

Identification of Excluded Capital Interests

Generally, the Proposed Regulations imposed a strict standard whereby a capital interest would only qualify as an Excluded Capital Interest if allocations to that interest were made in the “same manner” as allocations to certain significant unrelated non-service partners (“Unrelated Partners”). Meeting the “same manner” standard required that allocations be made to the Excluded Capital Interest based on the relative capital accounts of the partners and that any Excluded Capital Interest be entitled to distributions on the same terms, priority, type and level of risk, rate of return and rights to cash or property as those interests held by Unrelated Partners.

Although the test imposed by the Proposed Regulations was aimed at preventing abusive arrangements whereby carried interest could be disguised as an Excluded Capital Interest, the “same manner” standard did not take into account many common, non-abusive business arrangements. The Final Regulations acknowledge this concern and treat as an Excluded Capital Interest any capital interest, allocations to which and distributions with respect to which are determined in a “similar manner” to those to and with respect to interests held by Unrelated Partners. Specifically, the Final Regulations address the following arrangements:

• Targeted Allocations: Rather than requiring that allocations be made in accordance with capital account balances, the Final Regulations require that allocations to an Excluded Capital Interest be “reasonably consistent” with allocations to interests held by Unrelated Partners. This should be sufficient to ensure that the commonly used “targeted” allocation method (i.e., tying allocations to distribution rights) will not disqualify a fund manager’s capital interest as an Excluded Capital Interest even though under this method allocations are not technically in accordance with capital account balances.
• Management Fees: Many funds provide that Unrelated Partners are required to pay management fees to the fund manager, while the managers themselves are not required to do so with respect to their capital interest (given that this would essentially amount to their paying management fees to themselves). The Final Regulations expressly provide that this arrangement will not cause an interest to fail to qualify as an Excluded Capital Interest.
• Tax Distributions: Fund managers are often entitled to tax distributions with respect to both their carried interest and their capital interests while Unrelated Partners are not. The Final Regulations explicitly state that such an arrangement will not cause an interest to fail to qualify as an Excluded Capital interest provided that such tax distributions are treated as advances against future distributions. Given this proviso, funds should confirm that their partnership agreement expressly provides that tax distributions are in fact advances against other distributions.
• Investment-by-Investment: Funds often will determine the economic rights of their investors (and the fund’s managers) on an investment-by-investment basis and/or through separate “classes” with different economic rights. In such funds, it may be the case that no two investors have the same allocation or distribution rights, and therefore a fund manager’s capital interest may not be the same or sufficiently similar to interests held by Unrelated Partners in the aggregate so as to constitute an Excluded Capital Interest. To address this concern, the Final Regulations permit Excluded Capital Interests to be compared to interests held by Unrelated Investors with respect to each investment or within each class.

The Final Regulations do not, however, eliminate the Proposed Regulations’ record-keeping requirements necessary in order to establish that an interest is an Excluded Capital Interest. As a result, and as described in our prior Client Alert, fund managers will still need to ensure that their fund’s partnership agreement and books and records are sufficient to distinguish their APIs from their Excluded Capital Interests (including by issuing separate units in respect of API and Excluded Capital Interests).

Capital Interests Acquired with Related Party Loans

Treasury had been concerned that fund managers could disguise what would be an API as an Excluded Capital Interest by “acquiring” a capital interest with proceeds of a loan from another partner or the partnership or a person related to either one, while never actually intending repay that loan. As a result, the Proposed Regulations prohibited any capital interests funded with loans funded by other partners or the partnership from qualifying as Excluded Capital Interests. Commentators pointed out that the exclusion was overbroad as it is not the case all partner debt-financed capital interests should be viewed as abusive and that existing tax law already provides a standard to identify what constitutes bona fide debt. In response, the Final Regulations mostly retain the rule in the Proposed Regulations, but provide a broad exception for capital interests financed with loans that a fund manager is “personally liable” to repay. Under the Final Regulations, this is the case if the loan is fully recourse to the manager, the manager has no right to reimbursement for the loan payments from any other person, and the loan is not guaranteed by any other person.

Acceleration on Related Party Transfer

Under Section 1061, a person who transfers an API to a related person must include in gross income the amount of gain with respect to that interest that is attributable to assets the underlying partnership has held for not more than 3 years. The Proposed Regulations interpreted that requirement to mean that any transfer of an API at a gain would result in that gain being recognized by the transferor even where the transfer otherwise was a non-recognition transaction. As discussed in our prior Client Alert, this raised significant concerns that certain non-abusive transfers, including transfers for estate and gift planning purposes, could result in the immediate recognition of STCG.

Treasury acknowledged these concerns, and the Final Regulations do not independently accelerate the recognition of gain upon a transfer to a related person; instead, the Final Regulations only require the recharacterization of certain gain that would otherwise be recognized on that transfer. Specifically, if a taxpayer would otherwise recognize LTCG on the transfer of an API to a related party, that gain will be recharacterized as STCG in an amount equal to the STCG the taxpayer would have recognized (taking into account any recharacterization under Section 1061) if the partnership had sold all of its assets for their fair market value immediately prior to the transfer of the API (a “Deemed Liquidation”). This approach is a welcome change for fund managers that were concerned that common estate and gift planning transfers of APIs that would ordinarily not require the recognition of gain would nevertheless have substantial and unanticipated adverse tax consequences.

Look-through Rules

While Section 1061 does not ordinarily apply to the sale of an API to an unrelated third party, the Proposed Regulations provided that a “look-through” rule would apply if the assets of the underlying partnership met a “Substantially All Test.”² Under this look-through rule, the character as LTCG or STCG of the gain recognized by the transferor of an API was to be determined under the Deemed Liquidation method described above.

The Final Regulations modify the look-through rule by eliminating the Substantially All Test and focusing more narrowly on what Treasury views as abusive situations. Namely, the look-through rule will only apply if: (a) the taxpayer would have held the API for 3 years or less when ignoring any period prior to the date Unrelated Investors were required to make substantial capital contributions to the partnership (i.e., to prevent fund managers from circumventing Section 1061 by prematurely issuing carried interest before the fund is in operation) or (b) a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under Section 1061. While this narrower look-through rule should ultimately capture fewer non-abusive API transfers, the technical holding period determinations required by the Final Regulations will still necessitate careful consideration prior to any transfer of an API.

Mitigation Strategies

Corporate Holders

Because Section 1061 by its terms does not apply to partnership interests held by corporations, practitioners had considered whether fund managers could hold their carried interest through “pass-through” corporations such as S-corporations and certain passive foreign investment companies “PFICs”) to avoid the adverse consequences of Section 1061. As discussed in our prior Client Alert, the Proposed Regulations had confirmed earlier guidance from Treasury that partnership interests held by these “pass-through” corporations may be APIs that are not excluded from Section 1061. In the preamble to the Final Regulations, Treasury acknowledged there are questions about its authority to promulgate such a rule, but nevertheless concluded it has the requisite authority and declined to change its approach. As we previously noted, any fund manager using an S-corporation or a PFIC to avoid the rules of Section 1061 should be prepared for a challenge by the IRS.

Carried Interest Waivers

As noted in our prior Client Alert, certain API holders have begun incorporating into their fund documents an ability to waive their right to receive allocations of partnership gain that would not be LTCG to them as a result of Section 1061 (a “Waiver Provision”). Under a typical Waiver Provision, the API holders are made whole by priority allocations (up to the amount waived) of gains from later sales of partnership assets that meet the three-year holding period requirement of Section 1061. In the preamble to the Proposed Regulations, Treasury had announced it would closely scrutinize Waiver Provisions and practitioners had hoped the Final Regulations would address the topic and provide rules to distinguish between permissible and abusive arrangements. But the Final Regulations are silent on this point. As a result, funds that have implemented or are considering implementing Waiver Provisions should continue to consult with their advisors regarding any further guidance that may be issued with respect to Waiver Provisions.³

Conclusion

The foregoing discussion describes the most significant changes made by the Final Regulations, but the Final Regulations also include a number of other technical changes that fund managers and their advisors must carefully consider. In addition, Treasury has indicated that many areas are still under consideration, including the treatment of family offices, reporting by PFICs and potential de minimis thresholds, among others. Furthermore, given that the tax treatment of carried interest continues to carry high political salience, the transition to Democratic control of Congress and the White House may result in further regulatory changes and possibly further statutory changes as well.

O’Melveny will be closely monitoring further developments in this area and can assist clients with analyzing and complying with the Final Regulations and any future guidance related to the taxation of carried interests. 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 The Substantially All Test would have been met 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.

³ Note that the other mitigation strategies considered by practitioners remain unaddressed as well.

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, Arthur V. Hazlitt, 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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