Proposed Changes to Carried Interest Rule (IRC §1061) Redefine Some Long-Term Capital Gains as Short-Term Gains

Regulations under IRC Section 1061, commonly referred to as the carried interest rule, were proposed by the IRS and the Treasury Department on July 31, 2020.  Most significantly, the proposed regulations contain detailed rules about how certain long-term capital gains are re-characterized as short-term capital gains for partners that hold an ‘applicable partnership interest.’

The proposed revisions also:

• Define numerous terms;
• Establish rules for calculating the re- characterized gain amount;
• Confirm that partnership interests held by S corporations are subject to IRC Section 1061;
• Clarify that IRC Section 1061 does not apply to IRC Section 1231 gains;
• Address the application of IRC Section 1061 to the transfer of an API to a related party; and
• Establish reporting requirements.

Background

IRC Section 1061 was added to the Internal Revenue Code in 2017 by the Tax Cuts and Jobs Act to prevent partners from characterizing income attributable to the performance of services as a long-term capital gain. To address this, IRC Section 1061(a) re-characterizes certain net long-term capital gains of a partner that holds one or more APIs as short-term capital gains. The gain that is re-characterized by IRC Section 1061 is an otherwise long-term capital gain attributable to the sale of assets, including an API, with a holding period of three years or less.

An API is an interest in a partnership that is 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” (ATB). An ATB is any activity conducted on a regular, continuous, and substantial basis which consists, in whole or in part, of raising or returning capital, and either (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition), or (ii) developing specified assets.

Definitions

Proposed Reg. Section 1.1061-1 defines more than 35 specific terms that affect the interpretation and applicability of the rule. The large number of defined terms reflects the complexity associated with the proposed regulations, as well as the IRS’s attempt to apply Section 1061 broadly. In order to fully comprehend the proposed regulations, one must first understand these defined terms, and that will require a significant amount of effort.

Gains Excluded From Section 1061

The proposed regulations provide that Section 1061 does not apply to any capital gain that is characterized as long-term or short-term without regard to the holding period rules of IRC Section 1222. As a result, Section 1231 gain, Section 1256 gain, and qualified dividends, are not subject to the re-characterization rules of Section 1061.

Substantial Services Presumption

 A partnership interest is an API if it is transferred in connection with the performance of “substantial services.” The proposed regulations presume that services are substantial with respect to the partnership interest transferred in connection with those services. “This presumption is based on the assumption that the parties have economically equated the services performed with the potential value of the partnership interest transferred.”

Once an API Always an API

The proposed regulations provide that once a partnership interest is characterized as an API, it remains an API and never loses that characteristic unless and until one of the four exceptions set forth in Proposed Reg. Section 1.1061-3 applies. Thus, “even after a partner retires and provides no further services, if the retired partner continues to hold the partnership interest, it remains an API.”… “Further, an API remains an API if it is contributed to another Passthrough Entity or a trust or is held by an estate.”

An S Corporation is not a Corporation

IRC Section 1061(c)(4)(A) provides that an API does not include any interest in a partnership directly or indirectly held by a corporation. In Notice 2018-18, the IRS notified taxpayers that, for purposes of Section 1061, the term “corporation” does not include an S corporation. Similarly, the proposed regulations provide that a partnership interest held by an S corporation will be treated as an API if the interest otherwise meets the definition of an API.

Transfers to Related Persons

According to IRC Section 1061(d), if a taxpayer transfers an API to a related person in a transfer that would not otherwise be a taxable event, the taxpayer must include certain capital gain in gross income as short-term capital gain. The amount of gain required to be included in gross income as short-term capital gain is essentially equal to the partner’s share of the net built-in long-term capital gain in the partnership’s assets that have been held for three years or less.

Proposed Reg. Section 1.1061-5 defines the term “transfer” to include contributions, distributions, sales and exchanges, and gifts. However, a contribution to a partnership that qualifies for non-recognition treatment under IRC Section 721(a) is not treated as a transfer for purposes of IRC Section 1061 because any unrealized gains associated with the contributed API interest will be allocated to the contributing partner when they are actually recognized.

The proposed regulations also provide that if the basis of the transferred API in the transferee’s hands is determined in whole or in part by the basis of the API in the transferor’s hands (before application of IRC Section 1061), then the basis of the transferred API shall be increased by the capital gain included in gross income by the transferor solely by reason of IRC Section 1061.

Finally, a “related person” for this purpose is a member of the taxpayer’s family (within the meaning of IRC Section 318(a)(1)) or a person who performed a service within the current calendar year or the preceding three calendar years in any ATB in which or for which the taxpayer performed a service. In other words, a related parson is a family member (i.e., parents, spouse, children, and grandchildren) or a colleague (or recent former colleague).

Reporting Requirements

A partnership in which a taxpayer holds an API is required to provide the taxpayer with the information necessary for the taxpayer to comply with IRC Section 1061. The proposed regulations provide that this information includes:

• The API One Year Distributive Share Amount;
• The Three Year Distributive Share Amount;
• Long-term capital gains and losses allocated to the taxpayer that are excluded from IRC Section 1061 under Proposed Reg. Section 1061-4(b)(6);
• Capital Interest Gains and Losses allocated to the taxpayer;
• API Holder Transition Amounts; and
• In the case of a disposition by the taxpayer of an interest in the partnership during the taxable year, any information required by the taxpayer to properly take the disposition into account under IRC Section

The preamble to the proposed regulations warns that penalties will apply to partnerships that fail to comply with the reporting rules set forth in the proposed regulations and as further required in forms, instructions, or other guidance.

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