IRS finalizes regulations on carried interest recharacterization rule: Welcome clarifications, key takeaways

On January 7, 2021, the Treasury Department and the Internal Revenue Service (IRS) released final regulations under Section 1061 of the Internal Revenue Code of 1986, as amended (the Code). Section 1061 replaces the one-year holding period for favorable long-term capital gain treatment with a three-year holding period for taxpayers who hold an “applicable partnership interest” (API). Capital gain caught by the Section 1061 recharacterization rule is treated as short-term capital gain taxable at ordinary income rates. The Final Regulations retain the basic approach and structure of the proposed regulations issued on July 31, 2020, with certain significant revisions. For a description of the Proposed Regulations, see our alert, “Proposed carried interest regulations contain some good news, but many more traps for the unwary.” This alert outlines some of the significant changes in the Final Regulations, many of which address areas of concern we noted in the prior alert.

Background

As a brief refresher, Congress enacted the Section 1061 recharacterization rule in 2017 to limit the ability of sponsors and managers of private equity and hedge funds (collectively, the general partner) to obtain favorable long-term capital gain taxation of their so-called “carried interests.” The Section 1061 recharacterization rule applies to an API, which is a partnership interest held by, or transferred to, a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or by any other related person, in any applicable trade or business, which generally means raising capital for investment. See the diagram for an illustration of what is an API.

An API does not include a partnership interest held by a corporation (other than a subchapter S corporation, as has been made clear in subsequent guidance), or any partnership interest funded with capital contributions (capital interest) that provides the holder with a right to share in partnership capital commensurate with the amount of capital contributed or the value of such interest is subject to tax as compensation when received or vested (under Section 83 of the Code) (the Capital Interest Exception).

The Capital Interest Exception

As discussed in our prior alert, the Proposed Regulations’ implementation of the Capital Interest Exception was overly restrictive. The Final Regulations provide significant and welcome changes to the Capital Interest Exception.

Customary differences in GP interests vs. LP interests do not disqualify GP Interests from Capital Interest Exception. Under the Final Regulations, the Capital Interest Exception applies if capital account allocations made to the general partner in respect of its capital interest are determined and calculated in a manner similar to allocations on funded capital contributions of significant unrelated limited partners (ie, fund limited partners, apart from the general partner, holding five percent or more of the aggregate capital interests in the fund at the time the allocations are made). The Final Regulations make clear, however, that typical differences between a general partner’s capital interest and a fund investor’s capital interest (for example, the right to tax distributions and no charges for management fees or carried interest) will not cause a general partner’s capital interest to fail this “in a manner similar” requirement, and thus remain eligible for the Capital Interest Exception.

• Clear identification of capital interests required. The Final Regulations require that, in order to be eligible for the Capital Interest Exception, the fund’s operating agreement and its books and records must clearly identify capital interest allocations to the general partner. We recommend that general partners and their fund counsel review their fund documentation and administrative functions to ensure that they adequately identify and account for capital interest allocations made to the general partner’s capital interest, and to revise their documents and systems where necessary.
• Capital interests may be funded with full recourse loans. The Proposed Regulations imposed significant restrictions on the ability of individual members of the general partner to borrow in order to fund a capital interest. The Final Regulations provide that a capital interest may qualify for the Capital Interest Exception even if funded by a loan or advance from another partner in the fund (or any related person other than the fund) to an individual service provider provided that (i) the loan is fully recourse to the individual service provider, (ii) with respect to which the individual service provider has no right to reimbursement from any other person and (iii) the loan is not guaranteed by any other person.
• Retained capital gains qualify for Capital Interest Exception. The Final Regulations recognize that allocations of long-term capital gain with respect to an API may qualify for the Capital Interest Exception.
• Tiered fund structures. The Final Regulations provide that capital interest allocations from a lower-tier entity (typically, the fund itself) to an upper-tier entity (typically the general partner) retain their character and qualify for the Capital Interest Exception, provided allocations at the upper-tier entity are consistent with common partnership tax accounting requirements. Here again it would be prudent for general partners and their fund counsel to review their fund documentation to ensure their tiered structures meet the requirements of the Final Regulations.

Other significant changes

• No gain acceleration on related party transfers. Our prior alert noted that the Proposed Regulations seemed to indicate that some transfers of interests in the general partner to a related party (typically, estate planning-related transfers to a family member or general partner restructuring-related transfers to a colleague) could accelerate the recognition of capital gain. In a welcome clarification, the Final Regulations provide that Section 1061 is a recharacterization rule and not a timing rule, and that otherwise tax-deferred transfers of general partner interests to a related party should not trigger immediate income recognition in an otherwise nontaxable transfer.
• Look-through rule scaled back. The Final Regulations limit application of the look-through rule, which could recharacterize long-term gain recognized in a taxable disposition of an interest in the general partner, to situations where, at the time of the disposition, (i) Section 1061’s three-year holding period requirement would not be satisfied if the holding period of such interest were determined by disregarding the period prior to the date on which unrelated limited partners of the fund are first obligated to fund capital commitments or (ii) one or more transactions have taken place with a principal purpose of avoiding recharacterization under Section 1061.
• Carry waivers. It remains unclear under the Final Regulations how the IRS would treat carried interest deferral or waiver arrangements commonly utilized by funds and general partners to deal with the three-year holding period requirement of Section 1061.

Key takeaways and action items

• Gains from direct sale of real estate and other Section 1231 property are excluded. The Final Regulations confirm that a direct sale of real estate (or other Section 1231 property) is not subject to the three-year recharacterization rule. This favorable exclusion, however, does not apply to sales of partnership interests in a partnership that owns real estate (or Section 1231 property).
• Tax planning on sales is key. Section 1061 and the Final Regulations are very formalistic, and the tax results of a sale/disposition transaction can be dramatically different depending on how the transaction is structured.
• Consider changes in partnership/LLC documents to qualify for Capital Interest Exception. General partners should consider amending existing agreements to incorporate the specific identification requirements to qualify ownership interests for the Capital Interest Exception. Similarly, general partners should consider structuring new entities and ownership interests differently (such as expressly separating capital interests and carried interests) to force compliance with the specific identification requirements.
• The API net is very broad. While the Final Regulations corrected/relaxed many unfavorable rules, the definition of what is an API remains very broad. Generally, taxpayers/general partners should assume all carried interests or profits interests will be treated as APIs, even the “promote” going to a developer partner in a typical single-asset real estate joint venture arrangement.
• No grandfathering of existing interests/partnerships. The Final Regulations generally apply to taxable years beginning on or after the date they are filed for public inspection in the Federal Register. However, taxpayers/general partners are reminded that while the Final Regulations by their terms apply prospectively, all existing carried interests are potentially subject to the Section 1061 recharacterization rule.

Looking forward

The Final Regulations provide some welcome clarifications of the Proposed Regulations and better reflect how general partner interests in their funds are structured in practice. However, the Final Regulations are still very complex, and we expect further guidance to be issued under Section 1061.

Looming over all of this, however, is Democratic control of the Congress and the White House beginning on January 20, 2021, and the increased possibility of changes to the scope of Section 1061 or new legislation that affects carried interests. We will continue to monitor any additional developments and provide alerts as they arise.