under section 1061 of the tax code. Section 1061 imposes a three-year holding period as a precondition to recognizing long-term capital gains on carried interests issued to investment professionals, and otherwise treats the capital gains as short-term capital gains. Individuals are taxed at preferential rates on long-term capital gains, but not on short-term capital gains.
The final regulations largely adopt proposed regulations that were issued in July 2020 (which we discussed here) while making some taxpayer-favorable changes, including:
- Expansion of capital interest exception. The final regulations reduce the situations under which section 1061 would recharacterize gains from invested capital as short-term capital gains.
- Limitation of lookthrough rule. The final regulations limit the applicability of the “lookthrough rule” contained in the proposed regulations.
- No gain acceleration on related-person transfers. The final regulations do not require taxpayers to recognize gain on a transfer of a carried interest to a related person if the transfer is otherwise tax-free.
Here are some of the most significant aspects of the final regulations:
- Applicable partnership interest. Section 1061 applies only to applicable partnership interests (APIs). Under the final regulations, virtually all carried interests issued to investment professionals (either directly or through an aggregating entity, such as a fund’s general partner) are APIs. However, APIs do not include (1) interests in C corporations, other than a passive foreign investment company with respect to which a qualified electing fund election is in effect, (2) certain capital interests, or (3) certain partnership interests held by employees of entities not engaged in an investment advisory business. Like the proposed regulations, the final regulations apply section 1061 to carried interests held by S corporations.
- Capital interests. An interest that has a positive liquidation value at grant (e.g., an interest received in exchange for a capital contribution) generally is not an API if allocations in respect of the interest are made in a “similar manner” to allocations with respect to capital interests held by similarly situated non-investment professionals who (1) are unrelated to the investment professional holding the capital interest and (2) have contributed at least 5% of the partnership’s aggregate capital. The final regulations provide that allocations to an investment professional can be “similar to” allocations to non-investment professionals even if the investment professional’s allocations are subordinated to other allocations or are unreduced by managed fees or carry, the investment professional is entitled to tax advances, or the partnership permits investors to opt out of certain investments. By contrast, the proposed regulations had required all putative capital interest allocations to be “made in the same manner to all partners,” and thus would have treated an investment professional’s capital interest as an API in these situations. A partnership interest received in exchange for a contribution of funds loaned or guaranteed by the partnership, another partner, or a related person (such as the management company) is not a capital interest unless the investment professional is personally liable for the loan. Loaned funds that are excluded from the definition of capital interest are treated as capital contributions (and thus give rise to a capital interest) only as they are paid down from the investment professional’s own funds.
- Holding period. Like the proposed regulations, the final regulations determine the three-year holding period in section 1061 by reference to the owner of the asset sold, whether the asset is the carried interest itself or an asset held by the partnership that issued the carried interest. To read more click here
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