On July 31, 2020, the IRS issued proposed regulations ([REG-107213-18]) under Section 1061 of the Internal Revenue Code (the “Code”, and such proposed regulations, the “Proposed Regulations”) applicable to, among other things, common carried interest arrangements of private equity funds (“Funds,” or where stated in the singular form, a “Fund”). The Proposed Regulations are generally effective for taxable years beginning on or after the date final regulations are published in the Federal Register. However, other than with respect to certain transition rules, taxpayers are generally permitted to rely on the Proposed Regulations for taxable years prior to the date final regulations are adopted, provided they follow the Proposed Regulations in their entirety and in a consistent manner. It seems unlikely at this time that a Fund would in fact choose to rely on the Proposed Regulations in advance of final regulations being adopted.
As discussed below, the Proposed Regulations take some surprising positions in connection with capital interests of sponsors and create a new look-through approach for certain dispositions of partnership interests subject to these rules. Also notable is that the Proposed Regulations do not specifically address the validity of carry deferral or waiver mechanisms that sponsors and Funds commonly employ with a view toward meeting the 3-Year Holding Period Rules (described below) through adjustments to the timing of allocations and a sponsor’s participation in realization events. However, the preamble does note that taxpayers should be aware that such arrangements could be challenged under existing law and IRS guidance depending on the applicable facts and circumstances.
A Fund will typically incentivize its sponsor with the grant of a “carried interest” in the Fund whereby the sponsor (the “General Partner”) is permitted to participate in the upside returns of the Fund disproportionately to its invested capital after certain performance hurdles have been satisfied for the benefit of capital investors (“Limited Partners”). Historically, the General Partner would be taxed in the same manner as taxable Limited Partners in a Fund. For example, the Fund’s income allocable to the Limited Partners and the General Partner would retain its Fund-level character as either ordinary income or capital gain. Fund investments are typically structured so that the vast majority of the Fund’s income qualifies as long-term capital gain, provided such investments are held for more than one year as of the time of sale or other disposition. Accordingly, a General Partner’s distributive share of a Fund’s income has historically been comprised primarily of long-term capital gain.
As a result of the enactment of the Tax Cuts and Jobs Act of 2017, under new Section 1061 of the Code, the General Partner is entitled to long-term capital gain treatment with respect to its carried interest received in the Fund if it satisfies an extended three year holding period with respect to such carried interest (the “3-Year Holding Period Rules”). The 3-Year Holding Period Rules apply where the holder of a carried interest conducts an “applicable trade or business.” An “applicable trade or business” for this purpose generally includes typical Fund sponsor activities such as raising or returning capital and investing or developing specified investment-type assets. The 3-Year Holding Period Rules do not apply to Limited Partners or any holder of a “capital interest” in the Fund generally. In addition, the 3-Year Holding Period Rules do not apply to certain partnership interests held by employees of entities that are not engaged in an “applicable trade or business” (e.g., profits interests received by portfolio company management as incentive compensation).
Sales of Fund Assets and In-Kind Distributions
Although the Proposed Regulations are complex and contain a number of mechanical and technical provisions, broadly speaking, they clarify that the 3-Year Holding Period Rules under Section 1061 of the Code apply to the General Partner’s distributive share of capital gain or loss from the Fund’s disposition of assets. The Proposed Regulations confirm that for purposes of measuring the three year holding period, they will look to the holding period of the owner of the asset sold. Thus, where a Fund sells an asset, regardless of the General Partner’s holding period in its Fund interests, the Fund’s holding period in the asset will determine whether or not long-term capital gain treatment is available for the General Partner.
The Proposed Regulations also acknowledge that a distribution of property in-kind to a General Partner in respect of its carried interest will not accelerate gain recognition under the 3-Year Holding Period Rules. However, if the General Partner subsequently disposes of such property when it has a holding period of three years or less (taking into account the Fund’s holding period in such distributed asset prior to distribution to the General Partner for this purpose), the 3-Year Holding Period Rules will recharacterize any capital gain from the disposition of such property as short-term capital gain. Once the holding period in a distributed property exceeds three years, long-term capital gain treatment would be available to the General Partner in respect of such distributed property.
Sales or Dispositions of an API
Under the Proposed Regulations, unless certain look-through exceptions apply (described below), the 3-Year Holding Period Rules are applied at the partner level in connection with the sale of a partnership interest. For example, if an individual holds an interest in a General Partner and sells a portion of such interest, the general rule is that the individual’s holding period in the General Partner controls for purposes of applying the 3-Year Holding Period Rules. If, however, 80 percent or more of the assets (based on fair market value) of a Fund in which the General Partner holds its carried interest are comprised of certain assets that have a holding period to such Fund of three years or less, then even if the individual held the interest in the General Partner for more than three years, and the General Partner held its carried interest in the Fund for more than three years, all or a portion of the gain from the sale of such individual’s interest in the General Partner would be recharacterized as short-term capital gain.
Related Party Transfers
In the case of a direct or indirect transfer of a General Partner interest by one of its partners to a person related to such partner (generally, a family member or a co-worker that has performed services for the relevant Fund business), recognition of capital gain may be accelerated by such transfer even if such transfer is otherwise a nontaxable event. In determining the amount of gain from such a transfer to be recharacterized pursuant to the 3-Year Holding Period Rules, the Proposed Regulations look to the distributive share of capital gain that would have been allocated to the transferor partner if the Fund sold all assets held by it for three years or less for fair market value immediately before the transfer. Certain transfers, such as transfers to disregarded entities or tax-free transfers pursuant to Section 721 of the Code, do not implicate this acceleration rule. The related party transfer provisions of the Proposed Regulations are quite broad and could apply to Fund sponsor restructurings, estate planning and other transactions by and between sponsor service providers and/or their family members if the Proposed Regulations are finalized in their current form.
Capital Interest Exception
As discussed above, Section 1061 of the Code provides that capital interests in a partnership are not subject to the 3-Year Holding Period Rules (the “Capital Interest Exception”). In determining what qualifies as a “capital interest” for the purposes of qualifying for the Capital Interest Exception, the Proposed Regulations look to capital account balances and allocations to determine whether an interest in a Fund is eligible for the Capital Interest Exception by generally comparing sponsor interests to unrelated Limited Partner interests. The approach taken by the Proposed Regulations is narrow, mechanical and seems unlikely to be satisfied by many common sponsor capital arrangements. As such, the Proposed Regulations may cause sponsor capital interests to be subject to the 3-Year Holding Period Rules (and possible recharacterization as short-term capital gain). Finally, the Proposed Regulations also seem to require sponsor capital to be subject to carried interest in order to qualify for the Capital Interest Exception and, any such carry would be subject to the 3-Year Holding Period Rules. Therefore, if the Proposed Regulations are finalized as drafted, many sponsors may need to reevaluate how they structure their capital interests in respect of Funds.
REIT Look-Through Rules
In addition to clarifying the basic application of the 3-Year Holding Period Rules, the Proposed Regulations also include special rules for REIT capital gain dividends. Specifically, the Proposed Regulations require a REIT to report whether the REIT’s holding period in the property that it sold to generate the capital gains dividend was three years or less. Any such capital gain dividend allocable to the General Partner would be subject to recharacterization as short-term capital gain. Note that this look-through rule also applies to RICs.
Please reach out to any of your Weil Tax contacts if you have any questions about how the Proposed Regulations may impact your specific circumstances.