Key Changes Introduced by the Final Regulations

On January 7, 2021, the Internal Revenue Service (IRS) released final regulations (the Final Regulations) relating to the scope and applicability of Internal Revenue Code Section 1061. The Final Regulations retain the basic approach of the Proposed Regulations that were released on July 31, 2020, and published in the Federal Register on August 14, 2020, with certain significant changes. We previously discussed the Proposed Regulations in an earlier alert published here. This alert highlights certain changes made to the Proposed Regulations as well as certain provisions of the Proposed Regulations left unchanged in the Final Regulations.

Key Changes Introduced by the Final Regulations

Capital Interest Exception

An applicable partnership interest (API) does not include a capital interest that provides the holder the right to share in partnership capital commensurate with the amount of capital contributed. In general, this exception was meant to provide relief for any portion of a partner’s allocation that was based not on a pure profits interest, but rather on capital that had been contributed to, or reinvested in, the partnership. This is standard practice for fund managers to commit investment capital into the funds they manage (“skin in the game”).

Under the Proposed Regulations, the scope of this exception was narrowly defined whereby an allocation would qualify for this exception only if it was made in the “same manner” to all partners. The Proposed Regulations further indicated that an allocation would generally be deemed to satisfy the “same manner” requirement if it were based on relative capital account balances of the partners and the terms, priority, type, level of risk, rate of return, and if distribution rights were the same.

The Final Regulations replace the “same manner” approach with a “similar manner” requirement, meaning that allocation and distribution rights with respect to a fund manager’s capital interests must now be reasonably consistent with such rights applicable to all other limited partners with a significant aggregate capital account balance in a fund (still defined as at least 5% or more of the aggregate capital account balances of the fund). The Final Regulations clarify that this “similar manner” analysis can be done on a class-by-class or deal-by-deal basis and that capital interests can qualify for this exception even if they are not subject to management fees, incentive allocations or entitled to tax distributions. The Final Regulations also provide that allocations on the capital interest be clearly identified as separate and apart from allocations on the carried interest in the partnership agreement and in contemporaneous books and records of the partnership. Funds should review their applicable partnership agreements to ensure that such agreements meet the clear definition requirements under the capital interest gains and losses exception.

Under the Proposed Regulations, the capital interest exception would not apply to contributions to a capital account directly or indirectly attributable to any loan made or guaranteed by any other partner, the partnership, or a related entity, or person. Such disqualified arrangements could include, but are not limited to, a loan from the management company to the general partner or members of the general partner, a loan by the fund to the general partner or even a bank loan to the fund manager that is guaranteed by the management company or other partners. While the Final Regulations retain this general rule in relation to capital contributions funded by loans, they adopt a compromise approach where proceeds from a related-party loan can be contributed to create a qualifying capital interest if the API holder is personally liable for the repayment of the debt. Such API holder will be considered personally liable for the repayment of the debt if (1) the loan is fully recourse to the individual API holder; (2) the API holder has no right to reimbursement from any other person; and (3) the loan or advance is not guaranteed by any other person.

Transfers of APIs to Related Persons

Section 1061(d) generally provides that, if a taxpayer transfers, directly or indirectly, any API that has been held for three years or less to a person related to the taxpayer, the transfer is taxable. The Proposed Regulations broadly defined transfer to include nonrecognition transactions such as gifts or contributions to a partnership thereby effectively accelerating gain in a transaction that would otherwise be nontaxable.

The Final Regulations helpfully clarify that Section 1061(d) does not accelerate gain with respect to all transfers to related parties and applies only to transfers where gain is recognized. Since nontaxable transactions such as contributions to partnerships and gifting of carried interest are often used in estate planning for fund managers, this clarification is a welcome change. Nonetheless, any future realized gains with respect to such transferred APIs would still remain subject to potential Section 1061 recharacterization.

Lookthrough Rule for Certain API Distributions

Section 1061 generally substitutes a three-year holding period for long-term capital gains for the normal one-year holding period with regard to an API. Since a partnership interest is a capital asset that is separate and distinct from the underlying partnership assets, there is a possibility that an API itself could have a three-year-plus holding period while the underlying partnership assets could have significantly shorter holding periods; thus potentially leading to a better result to the API holder on the sale of the API than on the sale of the underlying assets. However, under the Proposed Regulations, if gain with respect to “substantially all” (Substantially All Test or 80% Test) of the entity’s assets would be recharacterized as short-term under Section 1061 if sold (due to a holding period of three years or less), then a gain on sale of such API would be recharacterized as short-term even if the seller of the API had satisfied the three-year holding period generally required under Section 1061.

Under the Final Regulations, the Lookthrough Rule has been significantly cut back with the elimination of the Substantially All Test or 80% Test, and replaced with an anti-abuse provision that is applicable only where, at the time of disposition of an API held for more than three years,

• the API would have a holding period of three years or less if the holding period of such API were determined by excluding any period before which third-party investors have capital commitments to the partnership,
• Example: Assume a partnership was formed in 2021 with modest contributions and an API was issued to a service provider partner, but the vast majority of the capital investment from third parties did not occur until several years later, in 2024. If the holder of the API attempted to sell the API in 2025, the API would effectively have a four-year holding period, but the Lookthrough Rule would disregard the three years prior to the large capital investments in 2024. Therefore, the gain on the 2025 sale of the API would be subject to Section 1061 because the API would be deemed to only have a one-year holding period.
• or a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under Section 1061(a).

Key Guidance Consistent with the Proposed Regulations

Carried Interest Waivers

The preamble to the Proposed Regulations noted that the Treasury Department and the IRS are aware of, and may challenge, carried interest waiver arrangements where an API holder seeks to allocate themselves gains generated from capital assets held for more than three years in lieu of capital gains held for less than three years, by waiving the rights to be allocated the shorter period capital gains. While the Proposed Regulations do not include specific provisions regarding these types of arrangements, they do acknowledge that the IRS is aware of carried interest waivers and may challenge them on audit under existing anti-abuse rules and previously proposed, but not finalized, regulations regarding management fee waivers. The Final Regulations and their preamble are silent on carried interest waivers, but the assumption is that the warning still stands. Therefore, careful and well thought out planning should continue to be used when implementing such arrangements.

Corporate Exception

Shortly after Section 1061 was enacted, taxpayers considered whether they could use the Corporate Exception to avoid Section 1061 by using a foreign corporation or an S corporation to hold an API. In Notice 2018-18, the IRS announced that the Section 1061 regulations would provide that partnership interests held by an S corporation would not fall within the Corporate Exception, but was silent as to the use of a foreign corporation for this purpose. The Proposed Regulations included the S corporation rule and also specified that a foreign corporation (Passive Foreign Investment Company or PFIC) with respect to which a shareholder made a Qualified Electing Fund (QEF) election are not “corporations” within the meaning of Section 1061. The Final Regulations confirm the position of the Proposed Regulations that both S corporations and PFICs that have a QEF election in effect are not treated as corporations for purposes of the Corporate Exception in Section 1061.

The Proposed Regulations provided that Section 1061(a) applies only to capital gains that would be treated as long-term capital gains under Sections 1222(3) & (4), therefore concluding that Section 1061 reporting or calculations does not include qualified dividend income, Section 1231 gains and Section 1256 gains. The Final Regulations retain that exclusion.

Similar to the Proposed Regulations, the Final Regulations treat property that is distributed to the API holder as being subject to recharacterization if the property had a holding period of less than three years at the time of the distribution. However, the final regulations provide that once the distributed property has a holding period of more than three years, it is no longer subject to recharacterization under Section 1061. However, unlike other property, the final regulations provide that previously distributed API property that now has a more than three-year holding period is simply excluded from the section 1061 analysis, such that losses from the sale of previously distributed property which has a more than three-year holding period cannot offset gain from a property with shorter holding periods for purposes of determining whether the API holder has net long-term capital gain.

Family Office Exception

Section 1061(b) provides that Section 1061 does not apply to “income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors,” which has been interpreted to apply to family offices (the “family office exception”). The preamble to the Final Regulations clarifies that Section 1061 is intended to apply to professional money managers that earn a carried interest to services for family offices, and that Treasury and the IRS have declined to issue special rules for other arrangements pending further study.

Reporting Requirements

Pass through entities must provide sufficient and timely information to their owners in order to allow direct and indirect API holders to comply with Section 1061. The Final Regulations generally retain the additional reporting requirements outlined in the Proposed Regulations as well as specifically indicating that passthrough entities could be subject to penalties under Section 6722 for failures in information reporting (with much more significant penalties in the event of intentional disregard of this requirement).

Effective Dates

The Final Regulations provide that they apply to taxable years beginning on or after the date they are published in the Federal Register. Accordingly, the Final Regulations will apply to taxpayers with a calendar tax year beginning January 1, 2022. However, taxpayers may choose to apply the Final Regulations to a tax year beginning after December 31, 2017, if they are applied consistently and entirely applied to such year and all later years. Consistent with the Proposed Regulations, the rules for APIs held by S corporations are effective for tax years beginning after December 31, 2017 (the effective date of Section 1061) and the rules for APIs held by PFICs that have made a QEF election are effective for tax years beginning after August 14, 2020 (the date the Proposed Regulations were published in the Federal Register).

The Final Regulations were a thoughtful response to industry concerns. The changes encompassed therein provide more flexibility and are more in tune with the alternative investment industry. However, applying these rules to existing and new funds will take thoughtful analysis and creative insight. Please contact E. George Teixeira or any member of Anchin’s Financial Services Practice at your earliest convenience if you have any questions or would like more information. We stand ready to help you plan effectively and to navigate these new rules and reporting requirements. In the meantime, we will continue to update you as more information becomes available.