IRC 1061 and Applicable Partnership Interests: Know the Tax Impacts

Internal Revenue Code (IRC) 1061 has significantly changed the taxation of carried interest for fund managers by designating certain interests as applicable partnership interests (APIs). It also requires a three-year holding period for underlying assets to qualify for long-term capital gains treatment. These relatively new regulations replace the historically favorable capital gains rates fund managers previously enjoyed. It’s essential for fund managers to stay informed about these developments to navigate potential tax implications effectively.

Applicable Partnership Interests and Implications for Fund Managers

API refers to an interest held by a partner in an investment partnership that is subject to the provisions of IRC 1061. This section aims to limit the favorable tax treatment that fund managers benefitted from on their carried interest. Specifically, gains from these interests are treated as short-term capital gains unless the underlying partnership assets have been held for more than three years.

For example, if a fund manager receives a carried interest from the fund and the fund has long-term gains from assets held for less than three years, those gains will be taxed at ordinary income rates. These rates can potentially reach up to 37% (excluding Net Investment Income Tax), instead of the lower long-term capital gains rates typically capped at 20%. This change could significantly impact the overall tax burden on fund managers, affecting their compensation structures. It’s important to note that certain types of gains and income, such as Section 1231, Section 1256 and Qualified Dividend Income (QDI), are exempt from the three-year holding period and may retain preferential tax treatment; a detailed discussion of these exceptions is beyond the scope of this section.

Fund managers must carefully assess the implications of IRC 1061 on their investment strategies. They need to monitor the holding periods of the assets to better understand the potential tax consequences of their carried interests. Additionally, they may need to consider restructuring their compensation or investment approaches to align with the new regulations, possibly emphasizing longer holding periods to qualify for more favorable tax treatment. While making such considerations, fund managers should also recognize that the provisions of IRC 1061 generally don’t apply to limited partners (LPs) invested in their funds. For LPs, the standard one-year holding period on the same assets is generally sufficient to qualify for preferential long-term capital gain treatment.

Reporting Requirements

From a compliance standpoint, investment partnerships must accurately report applicable partnership interests on Form 1065 and Schedule K-1 footnote disclosures to the API holder. Detailed disclosures regarding the character of income from these interests are essential to avoid IRS scrutiny. Any misreporting could lead to recharacterization of income and increase tax liabilities, resulting in penalties for the partnership and its partners.

Summary

IRC 1061 presents significant tax implications for APIs, particularly affecting how carried interests are treated for tax purposes. Fund managers should proactively evaluate the impacts of these regulations and consult with tax advisors to ensure proper compliance and make informed decisions that align with their financial objectives.

If you have questions about IRC 1061 or need advice on your specific situation, contact us. We’re here to help.

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