The IRS has released final Treasury Regulations under IRC Section 1061. The 2021 final regulations supplement the legislation enacted under the Tax Cuts & Jobs Act (TCJA) of 2017 and revise the proposed carried interest regulations issued in July 2020. The final regulations are generally less burdensome than those proposed and, importantly, clarify matters for many in the private fund industry.
The Basics of the New Regulations
The final regulations impact a taxpayer holding an applicable partnership interest (API) in connection with the performance of substantial services. An API, otherwise known as an incentive allocation, is typically held via a pass-through entity, such as a partnership, S Corporation or passive foreign investment company (PFIC) with a valid qualified electing fund (QEF) election in effect.
The regulations recharacterize certain net long-term capital gains of an API holder that owns one or more APIs as short-term capital gains. In the private fund context, an API holder includes fund managers, their principals and related parties. We will focus here on fund managers.
The 3 Biggest Changes to Carried Interests
The following items highlight the regulations’ greatest impact to the private fund industry:
- A more favorable set of rules defining when a fund manager’s book allocation qualifies for the capital interest exception;
- A relaxation of the rules that would have taxed many common non-abusive related party API transfers by fund managers; and
- Clarification that reinvested incentive allocation gains by fund managers, to the extent previously taxed, will be treated as a contribution of capital subject to the capital interest exception.
Capital Interest Exception
The capital interest exception applies to a fund manager’s contributed capital and reinvested realized API gains. This is the portion of a fund manager’s partnership interest that generates gains or losses that are excluded from the three-year holding period rules.
The language within the proposed regulations suggested a capital interest would be respected if the respective rights within the partnership agreement reflect the same manner for both the fund manager and unrelated investors. As such, this would have severely restricted the use of this exception, as many fund agreements have different terms for the fund manager relative to other partners.
However, the final regulations significantly ease this rigid requirement. A capital interest is now respected if the partnership agreement reflects that a capital account is maintained in a reasonably similar manner to the allocations with respect to capital interests of significant unrelated investors holding 5% or more of aggregate capital contributions. This would likely qualify many fund managers for the capital interest exception. Further, the books and records should clearly reflect the capital interest as separate from the API.
The final regulations also favorably clarify that a fund manager will be eligible for the capital interest exception even if they are not charged management fees on their capital interest, or if their capital interest is not subject to an incentive allocation. Similarly, an allocation to a fund manager can qualify as a capital interest if the manager has a right to receive tax distributions, while unrelated investors do not.
Many fund agreements do not provide language to differentiate between a fund manager’s capital interest versus their API. Therefore, fund managers should consider making amendments to their agreements to ensure they qualify for this exemption. While most managers use an independent third-party administrator to maintain books and records, they may not reflect a separate capital interest for the fund manager; the administrator may not have the tax information necessary to create the distinction. To qualify for this exemption, the manager will need to coordinate with their fund administrators and tax accountants to ensure they are maintaining separate books and records to reflect the capital interest and the API interest.
Related Party Transfers
The proposed regulations would have created a taxable event for certain transactions where a fund manager transfers their API to a related party, such as a family member or employee. The regulations would have accelerated gains and impacted previously non-abusive and non-taxable wealth planning strategies commonly used in the fund industry. For example, this may have created a taxable event where a fund manager gifts their API to a family member.
Conversely, the final regulations take a different approach and limit the application of this rule to apply to taxable transfers of API interests rather than to non-taxable transfers. With taxable related party transfers, an exchange is subject to recharacterization based on the holding period of the API transferred. With a non-taxable transfer to a related party, the transferred API remains an API in the hands of that party.
So overall, the final regulations create a more favorable provision that may recharacterize taxable gains out of what was previously poised to accelerate them.
Reinvested API Gains
The proposed regulations caused great consternation among tax accountants and fund managers alike relating to whether a manager’s reinvested API would qualify for the capital interest exception. A reinvested API in the private fund industry refers to a crystallized incentive allocation that is recontributed into or left in the fund by the fund manager. For tax purposes, a crystallized incentive allocation works by reallocating all the taxable components of income (commonly at 20%) from the limited partners to the fund manager.
The final regulations clarify that the three-year recharacterization rule does not apply to any reinvested or undistributed realized incentive allocation of the fund manager. The exception applies only to the realized long-term capital gain portion of the incentive allocation and unrealized API gains and losses are not included.
This may be an anomaly within the written language and may apply better in private equity situations, but an incentive allocation for most hedge funds includes not only realized long-term capital gain but also other income or loss components such as short-term capital gain, interest, dividends and operating expense items. The final regulations are silent on whether these form part of the realized incentive allocation subject to the capital interest exception. Absent further clarification, taxpayers are left to wonder if this was intended or an oversight.
Other Important Changes Impacting Fund Managers
Additionally, there were other important provisions included within the carried interest final regulations, which are worthy of mention as they generally clarify or ease the rules from the proposed regulations.
- Loans by partners to individual service providers will qualify for the capital interest exception to the service provider, where the service provider is personally liable for repayment.
- The look-through rule for API dispositions is simplified to apply in mainly abusive arrangements.
- Determining gain or loss upon a transfer that comprises both a capital interest and API interest is clarified.
- Mandatory revaluation rules included within the proposed regulations to determine unrealized API gains or losses are removed.
- Rules that allow API distributive amounts to include both gains and losses are changed.
- New computational netting rules are in place to determine the recharacterization amount that applies when greater than the three-year amount exceed the one-year amount.
- APIs held through a PFIC are confirmed to apply a reasonable approach to reporting gains subject to recharacterization.
- Complicated transition rule and transition election for positions held greater than three years at the implementation of the TCJA is eliminated.
- The special disclosure rules for capital gains distributions from regulated investment companies (RICs) and real estate investment trusts (REITs) are retained.
The carried interest final regulations are effective for tax years beginning on or after January 19, 2021. Therefore, for most calendar year taxpayers, they won’t be effective until 2022. A fund manager or passthrough entity may choose to apply this section to a taxable year beginning after December 31, 2017, provided they consistently apply the Section 1061 Regulations in their entirety to that year and all subsequent years.
Contact Peter Gilroy-Scott at firstname.lastname@example.org, David Gonano at email@example.com or a member of your service team to discuss this topic further.
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.