Under Proposed Changes, Which Trades and Businesses Will Be Subject to the Carried Interest Rule?

The proposed regulations under IRC Section 1061, commonly referred to as the carried interest rule, define a number of terms that affect the interpretation and applicability of the rule. Determining whether an activity is an “applicable trade or business (ATB)” under the regulations is an initial and necessary step in deciding whether Section 1061 applies to a taxpayer that holds an interest in that activity.

Section 1061 re-characterizes certain net long-term capital gains of a partner that holds one or more “applicable partnership interests” (APIs) as short-term capital gains. 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 ATB.

Thus, in order for an interest in a partnership to be an API (and for IRC Section 1061 to apply), the interest must be held or transferred in connection with the performance of services in an ATB.

IRC Section 1061(c)(2) defines an ATB as any activity that is conducted on a regular, continuous, and substantial basis, and involves:

• Raising or returning capital; and
• Investing in, disposing of, identifying, or developing “specified assets.”

The proposed regulations collectively refer to the actions of raising or returning capital and investing in, disposing of, identifying, or developing specified assets as “Specified Actions,” and clarify that Specified Actions must be conducted on a regular, continuous, and substantial basis in order for an activity to constitute an ATB.

However, the actions of (1) raising or returning capital, and (2) investing in, disposing of, identifying, or developing specified assets are not both required to be conducted in each taxable year for an activity to be treated as an ATB. For example, if investing or developing actions do not occur in the current taxable year with respect to an activity but sufficient raising or returning of capital actions occur in anticipation of future investing or developing actions, the activity will still be treated as an ATB.

The proposed regulations also expand on what it means to develop specified assets. Developing specified assets takes place “if it is represented to investors, lenders, regulators, or other interested parties that the value, price or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider.” Merely exercising voting rights with respect to shares owned does not amount to developing specified assets.

The proposed regulations identify specified assets as:

• Securities, including interests in partnerships qualifying as securities;
• Commodities;
• Real estate held for rental or investment;
• Cash or cash equivalents;
• An interest in a partnership to the extent that the partnership holds specified assets; and
• Options or derivative contracts with respect to any of the foregoing.

Commodities include any:

• Commodity which is actively traded;
• Notional principal contract with respect to any commodity that is actively traded;
• Derivative instrument (e.g., an option, forward contract, futures contract, or short position) in any commodity which is actively traded; and
• Position which is a hedge with respect to a commodity that is actively traded and which is clearly identified as such in the taxpayer’s records.

The preamble to the proposed regulations also indicates that “all corporate stock, regardless of the size of the corporation or whether the corporation is publicly traded, is a specified asset.” The preamble further indicates that “an interest in a partnership that is neither publicly traded nor widely held and whose assets consist of stocks, bonds, positions that are clearly identified hedges with respect to securities, and commodities” is also a specified asset.

What Does This All Mean?

The definition of an ATB under the proposed regulations is relatively broad and should capture most hedge funds and private equity funds as well as many real estate ventures and perhaps some exploration and production companies. Taxpayers that receive a partnership interest in these types of activities in connection with the performance of substantial services likely hold an API and, thus, are subject to the carried interest rule.

Fortunately, the proposed regulations provide that Section 1061 does not re-characterize Section 1231 gains. Thus, even if a taxpayer holds an API, Section 1061 may not have much if any impact on the taxpayer if the related ATB generates Section 1231 gains instead of long-term capital gains.

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