Carried interest tax treatment: IRS issues finalized regulations under Section 1061

Section 1061 – Background

Congress enacted IRC §1061 as part of the Tax Cuts and Jobs Act (“TCJA”) in 2017. The provision calls for an increase to three years from the current one year holding period to receive favorable long-term capital gains treatment on the sale of assets derived from holding an applicable partnership interest (“API”).

Fund managers receiving carried interest and gains related to holding a profits interest for the performance of certain services are subject to IRC §1061 and the extended holding period. Failure to satisfy the requirements could result in taxpayers being subject to the top ordinary tax rate of 37%, plus the 3.8% net investment income tax (“NIIT”), if applicable.

Finalized regulations

The finalized regulations follow most of the provisions of the proposed regulations that were issued at the end of July 2020 (see our previous Tax Alert on the proposed regulations for a detailed analysis) with some important clarifications:

Capital interest exemption

The regulations clarify that the “Capital Interest Exemption” from the proposed regulations would include capital contributions that were fully funded by a loan made, or guaranteed directly or indirectly, by the partnership (or any partner of the partnership), provided that the borrower has personal responsibility for repaying the loan.

Additionally, the final regulations clarify that the Capital Interest Exemption would apply through a tiered partnership structure, not solely to direct investment holdings.

Lastly, the allocation to a holder of an applicable partnership interest with respect to its capital interest must be determined and calculated in a similar manner commensurate with capital contributed, (as opposed to the same manner described in the proposed regulations), as the allocations with respect to capital interests held by similarly situated “unrelated non-service partners” (i.e., third-party investors) who have made significant aggregate capital contributions. 

Lookthrough rule for transfers of API

The final regulations replace the more complex look-through rules with a more straightforward test where the holding period of the direct owner of transferred property typically determines whether gain from the disposition of such property is recharacterized under Section 1061(a).

If, at the time of disposition, the direct holding period in an API exceeds three years, but the holding period as measured from the date that unrelated non-service partners legally commit to contribute substantial capital to the partnership with respect to which the API relates does not exceed three years, some or all of the realized gain is recharacterized under Section 1061(a).

The Treasury Department included the requirement for the unrelated service partner to contribute in order to prohibit dormant partnerships from being set up to prematurely start the three-year holding period. The look-through rule also applies to a transaction or series of transactions that occur with a principal purpose of avoiding potential gain recharacterization under Section 1061(a). The look-through rule similarly applies with respect to a passthrough interest issued by an S corporation or a PFIC to the extent the passthrough interest is treated as an API.

Related party transfers

The proposed regulations suggested that certain transfers of an API interest to a related party could potentially accelerate the recognition of capital gains even if the gain was actually unrealized. The final regulations clarify that, with respect to a direct or indirect transfer of an API interest to a related person, IRC §1061 is merely a recharacterization rule and does not trigger immediate income recognition in an otherwise non-taxable transfer.

Mazars’ Insight 

The final regulations have provided clarity on several issues raised with respect to the proposed regulations with many favorable changes. One such change allowing the capital interest exemption to members who fund their investment through loans will greatly expand the accessibility of carried interest to lower-level associates. The related party transfer clarification also removed the onerous provision from the proposed regulations that potentially would have triggered income on an otherwise non-taxable transaction.

Please contact your Mazars USA LLP professional for additional information.

Published on January 21, 2021

Authored Faye Tannenbaum and Joel Unger 

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.