Final regulations on tax treatment of carried interest

Background

The Tax Cuts and Jobs Act, enacted at the end of 2017, added Section¹ 1061, which generally increases the holding period for an individual to qualify for favorable long-term capital gain related to certain partnership interests (such as carried interests held by fund managers) from one year to three years. The increased holding period under Section 1061 applies to both gain on the sale of the “applicable partnership interests” (defined below) and on partnership gain allocated to partners holding applicable partnership interests. Proposed regulations were issued under Section 1061 in July 2020, and final regulations were issued in January 2021. These rules are particularly important to U.S. managers of hedge funds and private equity funds.

In general, payments for services are subject to federal income tax at ordinary income rates (the maximum current rate is 37%). However, in the case of a typical private equity fund or hedge fund organized as a partnership, the investment manager usually receives an interest in the profits of the fund (a “carried interest”) in exchange for services. In the case of partnerships, the character of a partnership’s gains are determined at the partnership level and flow through to the partners. As a result, when a fund recognizes long-term capital gain, a portion of that gain is allocated to management as carried interest. Historically, long-term capital gain allocated by a fund to its managers in respect of carried interest would be subject to tax at preferential federal income tax rates, currently 20%. Congress enacted Section 1061 in response to criticism of this favorable tax treatment. Capital gain of a fund manager that is subject to Section 1061, where the holding period is three years or less, is treated as short term capital gain subject to tax at ordinary income rates.

The following is a brief summary of certain of the key provisions addressed in the final regulations.

Application of Section 1061

Section 1061 applies to an applicable partnership interest (an “API”) held by or transferred to a taxpayer in connection with the performance by that person (or a related person) of substantial services in an applicable trade or business (an “ATB”). An API is any interest in a partnership which, directly or indirectly, is transferred to (or is held by) a person or pass-through entity in connection with the performance of substantial services by the person or entity, or by a “related person,” in any ATB unless an exception applies. An ATB is any activity conducted on a regular, continuous, and substantial basis which consists in whole or in part of: (a) raising or returning capital or (b) either (i) investing in (or disposing of) “Specified Assets” (or identifying Specified Assets for such investing and disposition), or (ii) developing Specified Assets. “Specified Assets” generally include securities, certain real estate, and cash. Thus, APIs generally include carried interest distributable to fund managers, although income allocated to interests other than carried interests may be captured by this rule. A financial instrument or contract, the value of which is determined in whole or in part by reference to the partnership, is treated as a partnership interest for purposes of these rules.

Gains not subject to Section 1061

Section 1061 and the regulations thereunder provide several exceptions to the three-year holding period requirement. The regulations confirm that, among other exceptions, Section 1061 does not apply to (i) to certain capital interests in a partnership (discussed below); (ii) gains from real estate treated as long-term gains under Section 1231; (iii) gain on commodities contracts treated as long-term gains under Section 1256; or (iv) any partnership interest held directly or indirectly by a corporation, other than an “S” corporation or a non-U.S. corporation that is a “passive foreign investment company” for U.S. federal income tax purposes and for which a “qualified electing fund” election has been made.

Capital interest exception

As noted above, Section 1061 provides an exception for gain with respect to “capital interests” (generally understood to mean gain earned with respect to invested capital). Under the final regulations, the capital interest exception will apply where allocation and distribution rights with respect to fund managers’ capital interests are “reasonably consistent”, with such rights applicable to limited partners with a “significant” aggregate capital account balance in a fund (defined as at least 5% or more of the aggregate capital account balances of the partnership). Whether allocation and distribution rights are “reasonably consistent” is determined by taking into account various economic factors, including the amount and timing of capital contributed, the rate of return, the terms, priority, type and level of risk, and rights to cash or property distributions during the partnership’s operations and on liquidation. However, the fact that interests held by managers are not subject to management fees or carried interest, are subordinated to the capital interests of third party investors, or have rights to tax distributions (as advances against future distributions), are ignored in determining whether those interests are capital interests.

The capital interest exception may apply to individual service providers who remain personally liable for the repayment of a loan, the proceeds of which are used to make a capital contribution. An individual service provider is treated as personally liable for these purposes only if (i) the loan is fully recourse to the individual; (ii) the individual has no right to reimbursement from any other person; and (iii) the loan is not guaranteed by any other person.

The capital interest exception may be applied on an investment-by-investment basis or on the basis of allocations made to a particular class of interests. Capital interest allocations must be clearly identified both under the partnership agreement and on the partnership’s contemporaneous books and records as separate and apart from allocations made to a fund manager with respect to its API.

Hedge funds typically revalue their assets on a mark-to-market basis. If a partnership’s revaluation of its assets causes a carried interest holder to have a capital account at any tier of the holding structure, the unrealized capital gain or loss attributable to the carried interest will retain its character under Section 1061. However, the final regulations confirm that future allocations to the holder attributable to the increase in the capital account will be exempt from Section 1061, so long as the allocations otherwise satisfy the Capital Interest Exception.

Transfers to related persons

Section 1061(d) requires recognition of gain upon the transfer of an API to certain related persons. The proposed regulations would have required gain recognition upon a transfer that otherwise qualifies for non-recognition treatment. The final regulations narrow the rule to exclude transfers (including gifts) where gain is not otherwise recognized.

Certain sales of APIs

The final regulations also provide that, under a special “Look through Rule,” which applies in certain anti-abuse situations, gain from the sale of an API (or an interest in a lower-tier partnership) may be recharacterized as short-term gain to the extent attributable to assets of the partnership held for three years or less, even if the API is held for more than three years.