Treatment of carried interest: Treasury and IRS release long-awaited proposed regulations

On July 31, the Treasury Department and the IRS released proposed regulations governing the treatment of “carried interest” under Internal Revenue Code (IRC) Section 1061. Fund managers have been waiting for much-needed guidance on the application of this impactful provision. 

Section 1061 was enacted as part of the Tax Cuts and Jobs Act (TCJA) in December 2017. The TCJA introduced the concept of an “applicable partnership interest” (API), which captures the carried interest, or profits interest, typically held by the general partner. The TCJA provides that holders of a profits interest will only be eligible for the preferential long-term capital gains rate with respect to gains realized on dispositions of capital assets, sold after Dec. 31, 2017, held for more than three years. 

With many unanswered questions from the original code section, the proposed regulations provide much-needed insight into how Section 1061 is to be interpreted and how Treasury may look at these arrangements in the future. Some highlights of the proposed regulations to consider are as follows. 

Section 1231, Section 1256 contracts, and qualified dividends 

The proposed regulations clarify that gains/losses from the sale of business property (Section 1231), regulated futures and certain other contracts (Section 1256), and certain dividends that receive a 20% preferential tax rate (qualified dividends) are not subject to Section 1061. 

Disposition of a partnership interest

The proposed regulations clarify that a disposition of a partnership interest that is an API is subject to Section 1061, and provides rules for determining the extent to which long-term capital gain or loss recognized on the disposition of a pass-through interest composed of both an API and a capital interest is excluded from Section 1061 because it is treated as a capital interest gain or loss. 

Capital gain dividends from regulated investment companies (RICs) and real estate investment trusts (REITs) 

There was uncertainty on whether long-term capital gains distributed from a RIC or a REIT would be excluded from Section 1061 if the gains were from assets held for more than three years. The proposed regulations provide that “capital gain treatment should be available to the extent that the capital gain dividend is attributable to capital assets held for more than three years or is attributable to assets that are not subject to Section 1061.” RICs and REITs must disclose additional information that will allow partnerships that invest in these assets to easily determine how much is potentially subject to the recharacterization rules.

Carry waivers 

To circumvent Section 1061, some funds changed their partnership agreements to allow fund managers to waive their rights to gains generated from the disposition of a partnership’s capital assets held for three years or less and substitute for these gains generated from capital assets held for more than three years. This allowed managers to potentially receive only greater-than-three-year gains as carried interest, thus none taxed at ordinary rates. The proposed regulations do not provide rules regarding this but do state that these arrangements may be challenged under examination. Fund managers will need to review their partnerships agreements to weigh the risk of having carry waiver clauses.

Definition of pass-through entity

The original statute defined entities that were subject to Section 1061 as entities other than corporations. Many interpreted this to mean that entities such as S corporations and passive foreign investment companies (PFICs) with a QEF election would fall outside of this rule, and managers changed their carried interest vehicles to these types of corporations. These were essentially corporations that  are treated as pass-through entities for federal income tax purposes. The proposed regulations state that pass-through entities include S corporations and PFICs; accordingly, these entities will be subject to Section 1061. 

Distribution of assets to carried interest holders

If assets are distributed to an owner of a pass-through subject to Section 1061, the subsequent gain on the sale of such assets would be subject to recharacterization if held for longer than one year but less than three years. This was done to prevent taxpayers from distributing unrealized gains to carried interest holders with the thought that such holders would not be subject to Section 1061 at the owner level.

Bona fide purchaser

If an unrelated third party – that is also not a service provider, at arm’s length – purchases the profits interest of a carried interest holder, the interest in the hands of the purchaser is not subject to Section 1061. In many cases, interests in a carried interest pass-through are sold by departing managers, or fund managers may want to bring in an outside investor to realize gains early by selling a piece of their interest versus waiting for the fund to allocate carry in the future. 

Installment sales

The proposed regulations clarify the installment sale rules with respect to gains that occurred before Jan. 1, 2018. The regulations state that installment gains recognized on receipts after Jan. 1, 2018, are subject to Section 1061 if the holding period of such asset was held for more than one but less than three years. For example, a fund sells stock held for two years for a gain in November of 2017, and the sales price will be collected in 2018 and 2019. The gains recognized in 2018 and 2019 will be subject to recharacterization.

In addition to the overview provided above, the proposed regulations address issues on how these rules are to be mechanically applied, as well as Transitional Rules for Applicable Partnership interests held on or before Jan. 1, 2018. These as well as other provisions will be covered in future tax alerts and webinars. 

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