Eagerly anticipated by the private fund industry, on July 31, 2020, the IRS and Department of Treasury released the carried interest proposed regulations under IRC Section 1061. The proposed regulations supplement the legislation enacted under the Tax Cuts & Jobs Act (TCJA) of 2017, impacting taxpayers holding an applicable partnership interest (API) in connection with the performance of services. Specifically, the proposed regulations clarify important provisions under Sec. 1061 and the need for private funds to consider a new tax election, as well as reporting and compliance requirements.
The Importance of Sec. 1061 to Private Funds and Their Managers
Sec. 1061 requires a taxpayer to use three years as the holding period for calculating favorable long-term capital gains by a fund manager or other related partner receiving performance allocations for providing substantial services to an applicable trade or business. An applicable trade or business encompasses almost all private investment funds, including hedge funds. The carried interest legislation has less relevance to private equity, real estate and certain long only strategies due to the three year holding period requirement for long-term gain characterization.
The impact of these rules will be critical for many private fund managers that hold APIs directly or indirectly and sell assets held for more than one year, but less than three years, due to the broad tax differential between gains treated as long-term (20%) and gains treated as short-term (37%).
Further, there were several unknowns with the initial TCJA legislation, which led fund managers to use certain planning strategies that minimized the impact of Sec. 1061. Fund managers have been waiting for regulations that would confirm some of those adopted strategies.
What Do the Carried Interest Proposed Regulations Clarify?
The proposed regulations confirm:
- The portion of a fund manager’s partnership interest, also known as proprietary capital, can generate capital interest gains or losses that are excluded from the Sec. 1061 holding period rules. A capital interest includes a fund manager’s contributed capital and realized API gains.
- Long-term capital gains determined under Secs. 1256 and 1231 are excluded from Sec. 1061. Qualified dividends and certain gains identified under the mixed straddle account rules are also excluded.
- An S Corporation is excluded from the definition of a corporation within Sec. 1061. The definition also excludes certain passive foreign investment companies (PFICs) with qualified electing fund (QEF) elections in effect. This is important, as Sec. 1061 created an exception to API holders that are corporations.
- In-kind distributions of property with respect to an API will not result in accelerated gains under Sec. 1061. However, the distribute partner will apply the Sec. 1061 holding period rules upon his or her ultimate disposal of such assets.
What are the New Tax Elections, Reporting and Compliance Considerations for Partnerships with APIs?
The proposed regulations create additional reporting and tax compliance demands on partnerships with APIs. Further, the proposed regulations adopt a partial entity approach to application where the existence of an API is determined at the entity level, and the Sec. 1061 gain is determined at the owner level. Below are the new provisions.
- A transition rule allows a partnership holding property for greater than three years at January 1, 2018, to elect with their 2020 or later year tax return to treat all long-term capital gains as partnership transition amounts. Such elected amounts are a separate category of gains and allow the partnership to categorize all qualifying assets into one category rather than separating them into either API assets or capital account assets
- New disclosures are required for partnerships issuing Schedule K1s to API holders to allow the API holder to comply with Sec. 1061 upon request of a partner.
- A look-through approach to disclose greater than three-year capital gains dividends paid by RICs and REITs will be allowed, as well as a look-through approach to disclose greater than three-year capital gains generated from PFICs with QEF elections in effect.
- A special look-through exception rule will apply when an API interest is disposed to deny long-term capital gain if 80% or more of the underlying assets held by an API are held less than three years.
Capital Account Interests and Transfers
The proposed regulations also attempt to more clearly define other areas, such as capital account interests and transfers by fund managers.
Capital Account Interests
Under the proposed regulations, a capital account interest, as stated earlier, is excluded from the Sec. 1061 holding period rules. In general, Sec. 1061 provides that a capital interest affords a taxpayer a right to share in the partnership capital commensurate with the amount of capital contributed. The proposed regulations further describe that a capital account interest will be respected if the partnership agreement reflects the same terms, same priority, risk, same rate of return and same liquidity terms for all partners. Further, the books and records should clearly segregate a capital account interest from an API. These requirements would essentially require the partner and partnership to clearly bifurcate the capital interest from the API to avoid an entire general partner interest being subject to Sec. 1061 treatment on the entire interest.
Fund Manager Transfers of API
The proposed regulations also address fund managers transferring an API to related parties, such as family members or employees of the fund manager. The regulations propose taxing what would normally be a tax free transfer to the extent of unrealized built-in gains held less than three years. This could have a major impact on common wealth planning strategies for fund managers who convert API interests into a capital interest or gift APIs to a taxpayer’s child. Fund managers should understand the implications and seek tax guidance before transferring or converting capital account to any related parties.
Potential IRS Challenge for Fee Waivers
Although not specifically addressed in the proposed regulations, the preamble discusses the practice of some fund managers to use carried interest fee waivers to circumvent Sec. 1061. The preamble states that similar arrangements may not be respected and may be subject to challenge.
What Needs Further Interpretation in the Proposed Regulations?
The examples in the proposed regulations provide some clarity but are less specific to common situations for hedge funds with annual carried interest allocations. In particular, many hedge fund general partners “reinvest” their carried interest into the fund and a portion of that incentive may relate to unrealized gains. These proposed regulations do not address the treatment of the economic return on the general partner’s capital account as either an API or a capital interest.
In addition, while the proposed regulations discuss a narrow exception for cost of services (management fee differences) in considering the capital account treatment of a general partner’s investment, they do not address other situations such as incentive allocation waivers on the general partner or affiliates capital account performance. In addition, other situations where managers may have slight variations in economics from other investors, like side pockets, are not addressed. Fund managers should analyze the specifics of these situations to determine the best course of action to avoid API treatment.
Fund Manager Considerations
While it is important to note the regulations are not final, taxpayers are permitted to rely on the carried interest proposed regulations before that time as long as they apply them in their entirety and in a consistent manner. Below are the areas fund managers with an API should begin taking a closer look at with their tax advisors:
- Review planning strategies considered or implemented following the TCJA.
- Be aware that the narrow definition of a capital interest, the reporting rules and the potential for a transition election will lead to additional reporting and tax compliance.
- Analyze fee arrangements and seek guidance to determine the adequacy of the provisions.
- At a minimum, review fund documents and discuss how to address the various categories of accounts per Sec. 1061 within the books and records.
Contact Peter Gilroy-Scott at firstname.lastname@example.org, Rob Velotta at email@example.com or a member of your service team to discuss this topic further.
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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law