Carried Interest Proposed Regulations Released
On July 31, 2020, the U.S. Department of the Treasury (Treasury) and the IRS released proposed regulations regarding carried interests targeted by Internal Revenue Code Section 1061, which provides for a three-year holding period in the case of net long-term capital gain with respect to certain partnership interests. This article will cover key aspects of the new rules that clarify or expand upon the statute included in the Tax Cuts and Jobs Act enacted on December 22, 2017.
Section 1061 recharacterizes net long-term capital gains with respect to certain partnership interests as short-term capital gains. Persons subject to tax on the net gain include individuals, simple and complex trusts, and estates. The provision applies to interests transferred in connection with the performance of services by a taxpayer in a trade or business that raises capital and invests or develops assets such as securities, commodities, real estate held for rental or investment, and options or derivative contracts. Such interests are common among hedge funds and private equity groups.
At a Glance
The proposed regulations:
- Confirm §1231 amounts, §1256 amounts, and qualified dividends are excluded from the calculation of the recharacterized gain
- Add a fifth exception to interests that fall into the category of applicable partnership interest and clarify that S corporations aren’t corporations for the purposes of the statute
- Provide a framework for determining the recharacterized amount of long-term capital gains with respect to an applicable partnership interest when held through a tiered structure
- Clarify that transfers of applicable partnership interests to related parties include—but aren’t limited to—contributions, distributions, sales and exchanges, and gifts
- Detail reporting requirements for owners and pass-through entities
Applicable Partnership Interests (API) & Applicable Trades or Businesses (ATB) Defined
Applicable Partnership Interest
An applicable partnership interest is an interest in a partnership that’s transferred to or held by a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.
Applicable Trades or Business
An applicable trade or business is any activity conducted on a regular, continuous, and substantial basis (whether conducted in one or more entities) that consists of raising or returning capital and either investing in (or disposing of) or developing specified assets.
APIs Don’t Include
- Interests held by non-ATB employees
- Interests held by corporations (not including S corps)
- Capital interests
- Income or gain attributable to family offices
- API purchased at fair market value by unrelated taxpayers
The existence of API is determined at the entity level, and the recharacterized capital gain is computed at the owner level subject to tax.
Section 1061 recharacterizes certain net long-term capital gain with respect to APIs as short-term capital gain. Capital gain may arise from direct disposition of an API; it also may include a distributive share of capital gain from such entity. The proposed regulations provide guidance for computing the recharacterized amount in various scenarios. In the simplest scenario, a taxpayer holds a direct profits interest in a partnership with no distributive shares of long-term capital gain. In this instance, the only recharacterized capital gain occurs if the taxpayer sells his/her API in three years or less. The recharacterization amount is harder to determine where a taxpayer has two or more holding periods in the same interest, holds a capital interest in addition to an API, or has distributive shares of API gains and losses from an interest in a tiered pass-through structure.
Items Highlighted by the Preamble
Long-Term Capital Gain Items Not Used
Section 1061(a) applies to assets that produce capital gains or losses that are treated as long-term capital gain under paragraphs (3) and (4) of §1222. The proposed regulations exclude §1231 amounts, §1256 amounts, and qualified dividends because the respective tax treatments are based on operations of other code sections and not in reference to the relevant paragraphs of §1222.
API Holder Transition Amounts
The proposed regulations provide that if a partnership were in existence on January 1, 2018, and had held assets more than three years as of that date, it may irrevocably elect to treat all long-term capital gains and losses from those assets as partnership transition amounts. Such amounts allocated to an API holder are treated as long-term capital gains and losses and aren’t subject to recharacterization under the proposed regulations.
A signed and dated election statement must be attached to the partnership’s Form 1065 for the first taxable year the entity treats gains as partnership transition amounts. In addition, the taxpayer must clearly and specifically identify all relevant assets in its books and records by the due date of the return, including extensions.
Installment Sale Gains
The proposed regulations clarify §1061 recharacterized amounts include gains from installment sales, even if the sale occurred prior to the statute’s effective date. Furthermore, the holding period on the date of disposition is used for the purposes of §1061.
Distribution of API Property
In general, property distributed from an API doesn’t accelerate the recognition of income. The property maintains its character in the hands of the distributee, who takes the same holding period as it was in the partnership. If the property is sold when the holding period is three years or less, the gain or loss is netted with other API gains and losses. Once the property is held for three years, the asset loses its API gain or loss status.
Disposition of API Held for More Than Three Years
In general, the proposed regulations don’t look through a partnership to its assets on the sale of a partnership interest. In the case of a directly held API with a holding period of more than three years, the look-through rule applies if the assets of the partnership in which the API is held meet the substantially all test. This test is met if 80 percent or more of the partnership assets based on fair market value would produce capital gains or losses if sold and have a holding period of three years or less. Cash and cash equivalents, 751(c) unrealized receivables, and 751(d) inventory items aren’t included in this test.
§1061(d) Transfers to Related Persons
Section 1061(d) accelerates the recognition of capital gain on a direct or indirect transfer of an API to a related person that wouldn’t otherwise be a taxable event and recharacterizes certain long-term capital gain as short-term capital gain. The proposed regulations clarify the term transfer includes—but isn’t limited to—contributions, distributions, sales and exchanges, and gifts.
A pass-through entity is required to provide the relevant taxpayer information needed to comply with §1061. Such information includes long-term capital gains on assets held longer than one year and long-term capital gains on assets held for three years or less. In addition, the pass-through entity must provide the adjustments that must be made to the distributive share of long-term capital gain or loss that would allow the taxpayer to independently calculate its recharacterized long-term capital gains. If these adjustments aren’t provided to the owner taxpayer, and if the owner taxpayer can’t otherwise substantiate all or part of those amounts to the secretary’s satisfaction, the IRS will treat the amount of the adjustments as zero.
Disclosure items include:
- Long-term capital gains on assets held longer than one year and long-term capital gains on assets held for three years or less
- Long-term capital gains and losses allocated to the owner of an API that are excluded from §1061 under regulation §1.1061-4(b)(6)
- Gains and losses allocable to capital interests
- Partnership transition amounts
- Any information required by the owner of an API to properly take a disposition of an API into account under §1061, including information for the look-through rule and any information required to determine its capital interest disposition amount
Form 8082 is necessary to report inconsistently with the information furnished by the pass-through entity.
The provisions of this section mostly apply to taxable years of direct and indirect owners beginning on or after the date of the Treasury decision adopting these regulations as final is published in the Federal Registry.
While this BKD Thoughtware® alert includes many significant issues contained within the guidance issued by the IRS and Treasury on July 31, 2020, there may be additional issues not discussed here that would affect your specific tax situation. Accordingly, we recommend that you reach out to your BKD Trusted Advisor™ or submit the Contact Us form below for help applying this guidance.