IRS Issues Proposed Carried Interest Regs; Warns Against Circumventing Rules

(Parker Tax Publishing August 2020)

The IRS issued proposed regulations under Code 1061, which was enacted as part of the Tax Cuts and Jobs Act of 2017 and which is aimed at curtailing the "carried interest" tax break available to investment fund managers. In the preamble to the proposed regulations, the IRS said it is aware that some taxpayers may seek to circumvent Code Sec. 1061 by waiving their rights to gains generated from the disposition of a partnership's capital assets but noted that such transactions may not be respected and may be challenged under Code Sec. 707 and various regulations and/or the substance over form or economic substance doctrines. REG-107213-18.

Background

The Tax Cuts and Jobs Act of 2017 (TCJA) made changes to the carried interest tax break, effective for tax years beginning after 2017. Carried interest is the portion of an investment fund's returns that is paid out to investment fund managers. A partnership tax structure is typically used for investment funds because it provides flow through treatment of income, expense, gains, and losses. Prior to TCJA, carried interest gains on assets held for a year or more were taxed at the more favorable long-term capital gains tax rates. TCJA enacted Code Sec. 1061, which provides that an investment fund's assets must be held for three years before the carried interest payment to an investment manager is taxed at long-term capital gain tax rates.

The three year holding period applies to applicable partnership interests (APIs). Under Code Sec. 1061(c)(1), an API is generally defined as any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. This rule does not apply to an interest held by a person who is employed by another entity that is conducting a trade or business (other than an applicable trade or business) and only provides services to such other entity. Under Code Sec. 1061(c)(4)(A), an API does not include any interest in a partnership directly or indirectly held by a corporation.

The term "applicable trade or business" is defined in Code Sec. 1061(c)(2) to mean any activity conducted on a regular, continuous, and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of (1) raising or returning capital, and (2) either (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition), or (ii) developing specified assets.

The term "specified asset" is defined in Code Sec. 1061(c)(3) to mean securities (as defined in Code Sec. 475(c)(2) without regard to the last sentence thereof), commodities (as defined in Code Sec. 475(e)(2)), real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership's proportionate interest in any of the foregoing.

In Notice 2018-18, the IRS announced its intention to issue regulations which provide that, effective for tax years beginning after December 31, 2017, the term "corporation" in Code Sec. 1061(c)(4)(A) does not include an S corporation. Thus, an S corporation cannot be used to get around the three-year holding period rule.

Proposed Regulations

On July 31, the IRS issued proposed regulations under Code Sec. 1061 in REG-107213-18. The proposed regulations rely on numerous definitions. They use the term "Recharacterization Amount" to refer to the difference between a taxpayer's net long-term capital gain with respect to one or more APIs and the taxpayer's net long-term capital gain with respect to these APIs if Code Sec. 1222(3) and (4), which define the terms long-term capital gain and long-term capital loss, respectively, are applied using a three-year holding period instead of a one-year holding period. The proposed regulations refer to the person who is subject to federal income tax on the Recharacterization Amount as the "Owner Taxpayer." Although an API can be held directly by an Owner Taxpayer, it also may be held indirectly through one or more passthrough entities (Passthrough Entities). The proposed regulations provide a framework for determining the Recharacterization Amount when an API is held through one or more tiers of Passthrough Entities (tiered structures).

The determination under the proposed regulations of a taxpayer's net long-term capital gain with respect to the taxpayer's APIs held during the tax year includes the taxpayer's combined net distributive share of long-term capital gain or loss from all APIs held during the tax year and the Owner Taxpayer's long-term capital gain and loss from the disposition of any APIs during the tax year. The proposed regulations refer to long-term capital gains and losses recognized with respect to an API as "API Gains and Losses." Unrealized API Gains and Losses are capital gains and losses with respect to an API that have not yet been realized. In a tiered structure of Passthrough Entities, API Gains and Losses and Unrealized API Gains and Losses retain their character as API Gains and Losses as they are allocated through the tiers.

Under the proposed regulations, API Gains and Losses do not include long-term capital gains determined under Code Sec. 1231 and Code Sec. 1256, qualified dividends, and any other capital gain that is characterized as long-term or short-term without regard to the holding period rules in Code Sec. 1222. Additionally, API Gains and Losses do not include API Holder Transition Amounts and Capital Interest Gains and Losses. API Holder Transition Amounts are allocations to the holder of an API (API Holder) of long-term capital gain and loss recognized on the disposition of assets held by the partnership for more than three years as of January 1, 2018, if the partnership has elected to treat these amounts as API Holder Transition Amounts. The term "Capital Interest Gains and Losses" are defined as long-term capital gains and losses with respect to an API Holder's capital investment in a Passthrough Entity.

The proposed regulations are divided into six sections: Prop. Reg. Sec. 1.1061-1 provides definitions of the terms used in Prop. Reg. Sec. 1.1061-1 through Prop. Reg. Sec. 1.1061-6. Prop. Reg. Sec. 1.1061-2 provides rules and examples regarding APIs and ATBs and Prop. Reg. Sec. 1.1061-3 provides guidance on the exceptions to an API, including the capital interest exception. Guidance on the computation of the Recharacterization Amount and computation examples are provided in Prop. Reg. Sec. 1.1061-4. Finally, Prop. Reg. Sec. 1.1061-5 provides guidance regarding the application of Code Sec. 1061(d) to transfers to certain related parties, while Prop. Reg. Sec. 1.1061-6 provides reporting rules.

Tax Avoidance Transactions

In the preamble to the proposed regulations, the IRS said that it is aware that taxpayers may seek to circumvent Code Sec. 1061(a) by waiving their rights to gains generated from the disposition of a partnership's capital assets held for three years or less and substituting for these amounts gains generated from capital assets held for more than three years. Alternatively, taxpayers may waive their rights to API Gains and substitute gains that are not taken into account for purposes of determining the Recharacterization Amount.

Some arrangements also may include the ability for an API Holder to periodically waive its right to an allocation of capital gains from all assets in favor of an allocation of capital gains from assets held for more than three years and/or a priority fill up allocation designed to replicate the economics of an arrangement in which the API Holder shares in all realized gains over the life of the fund. These arrangements, the IRS observed, are often referred to as "carry waivers" or "carried interest waivers." The IRS warned that these and similar arrangements may not be respected and may be challenged under Code Sec. 707(a)(2)(A), Reg. Sec. 1.701-2, and Reg. Sec. 1.704-1(b)(2)(iii), and/or the substance over form or economic substance doctrines.

For a discussion of the carried interest rules of Code Sec. 1061, see Parker Tax ¶29,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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