IRC Section 1061 Final Carried Interest Regulations Issued
On January 7, 2021, the Treasury Department released T.D. 9945 which provides the finalized regulatory guidance with respect to IRC Section1061. These regulations were published in the federal register on January 19, 2021 and became effective on that day. IRC Section 1061 re-characterizes certain net long-term capital gains of partners holding one or more applicable partnership interests (“API”) as short-term capital gains. Generally, an API holder’s distributive share of net long-term capital gain and/or gain on disposition of an API is re-characterized as short-term capital gain to the extent that the holding period of assets sold was more than one year, but not more than three years.
Under the statute, an API is defined as a partnership interest that is directly or indirectly transferred to (or held by) a taxpayer in connection with the performance of substantial services by the taxpayer or any other related person, in any applicable trade or business (“ATB”). However, any capital interest in a partnership which provides the taxpayer with a right to share in partnership capital commensurate with the amount of capital contributed (or issued to such taxpayer as taxable compensation) is not an API; this is referred to as the “capital interest exception.”
An ATB is any activity conducted on a regular, continuous and substantial basis which consists of raising or returning capital, and either (i) investing in (or disposing of) specified assets or identifying such assets for such investing or disposition, or (ii) developing specified assets. Specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing assets, and interests in partnerships to the extent of such partnerships’ proportionate interest in any of the foregoing assets.
On July 31, 2020, the Treasury Department issued proposed regulations that attempted to provide clear guidance with respect to how IRC Section 1061 was to be applied, but caused some uncertainty for taxpayers and practitioners alike due to several open questions. The final regulations generally adopt the proposed regulations and retain many of the guidance previously provided, but with some important revisions and clarifications.
- Expansion of the capital interest exception for capital gains allocated to “capital interests” held by taxpayers that also own APIs.
- Clarification that loan proceeds can be used to fund capital contributions that will qualify as a capital interest for purposes of the capital interest exception.
- Clarification that reinvestment of carried interest that has already been treated as an API gain will be treated as a capital interest for purposes of the capital interest exception.
- Simplification of the “Look-Through Rule” which provides that an API holder must look-through to the partnership’s holding period of its assets if the API was held for more than three years, and either (i) the holding period of the API would be three years or less if such holding period began on the date that an unrelated non-service partner was legally required to contribute substantial money or property directly or indirectly to the pass-through entity to which the API relates or (ii) the sale was part of a transaction or series of transactions that had a principal purpose of avoiding gain re-characterization under IRC Section 1061.
- Clarification that to the extent a transfer of an API to a related party was otherwise non-taxable, such transfer would not accelerate recognition of API gain.
In summary, the final carried interest regulations provide some much needed clarification to enable taxpayers and advisors to apply IRC Section 1061. Please consult your Cherry Bekaert tax professional to determine how these final regulations may affect you.