The Internal Revenue Service (IRS) on July 31, 2020, published proposed regulations (Proposed Regulations) on the tax treatment of certain partnership interests held in connection with the performance of services (such interests commonly referred to as carried interest). The Proposed Regulations are issued under a new provision of the Internal Revenue Code enacted as part of broader tax law changes adopted in late 2017, commonly referred to as the Tax Cuts and Jobs Act (or TCJA). Under new Section 1061 of the Internal Revenue Code (Section 1061), eligibility of holders to avail themselves of preferential long-term capital gains rates was curtailed in certain manners, generally imposing a longer holding period requirement of greater than three years as opposed to the default greater than one year to be eligible.
The Proposed Regulations provide insight into a variety of areas that were left open to interpretation since the enactment of the TCJA. Certain of the provisions resolve such uncertainties in a taxpayer favorable manner, such as by excluding certain real property gains and dividends from the ambit of the rules. Other provisions attempt to eliminate certain planning opportunities that stakeholders may have interpreted to exist through gaps in the statutory language. The Proposed Regulations also propose several complex calculation methodologies to apply the new provision, accompanied by new reporting requirements at the partnership and holder level.
Section 1061 applies to taxable years beginning after Dec. 31, 2017. By contrast, the Proposed Regulations will not be generally applicable until final regulations are published, and may be modified in whole or in part as the IRS considers comments from stakeholders. Taxpayers may affirmatively elect to apply and rely on the Proposed Regulations now, provided that they are adhered to in their entirety and applied consistently. It should be noted, however, that when finalized, certain rules directed at perceived abusive uses of S corporations or foreign corporations as holding companies will have retroactive effect.
Under Revenue Procedure guidance promulgated by the IRS in 1993, provided certain requirements are met, persons that receive partnership interests in exchange for providing services to a partnership may both avoid any income taxation upon receipt of the interest and take advantage of preferential long-term capital gains rates upon disposition of the interest. The treatment of such economic rights differs significantly from compensatory amounts paid in cash to a service provider, which are taxed immediately and at higher ordinary income rates. Unsurprisingly, the preferential status afforded to such compensatory partnership interests has been under repeated scrutiny over time. Despite the regularity of critical discussion, there has been little change in the federal taxation of such interests over time.
Section 1061 is not a repeal of the preferential status of such interests, and is not generally applicable to all such partnership interests. The IRS emphasizes this distinction in the preamble to the Proposed Regulations, noting that Section 1061 is narrower and broader. Section 1061 only applies if services are being rendered to a business engaged in investing in or developing on behalf of third parties securities, commodities or certain other specified assets of an investment nature. Thus, a manager of a widget-making business operated in pass-through form that receives equity compensation in the form of partnership interests is not subject to Section 1061.
Section 1061 also does not alter the taxation of the recipient upon receipt of the partnership interest, neither eliminating the ability to avoid taxation upon receipt under prior Revenue Procedure guidance, nor foreclosing the application of Section 1061 if the requirements to avoid taxation upon receipt are not met. Section 1061 does not alter the character of the income as "capital" either, only recharacterizing what may be long-term capital gain as short-term capital gain subject to the same rates of taxation as ordinary income. By not changing the character of the income, capital losses, which generally may only offset capital gains, remain available to eliminate such income. In addition, the Proposed Regulations provide that Section 1061 may apply to financial instruments or contracts that may not otherwise be treated as a partnership interest for general United States federal income tax purposes. Finally, it may be noted that long-term capital gains treatment is still available when subject to Section 1061, provided that a longer, greater than three-year holding period, rather than the default greater than one-year holding period, is met.
Certain basic principles of Section 1061 were clarified through the Proposed Regulations in a helpful and necessary manner. The Proposed Regulations make clear that the provision applies to gain recognized upon a disposition of a partnership interest, and also to gain recognized by the partnership and passed through to the partner, in each case applying the holding period of the holder of the asset. Thus, a partnership may recognize gain on the disposition of an asset held for greater than three years, and long-term capital gain treatment may be preserved when passed through to a partner holding a targeted partnership interest, even if the holder has not held the targeted partnership interest for greater than three years.
Consistent with the foregoing, when a targeted partnership interest is disposed of, the Proposed Regulations do not automatically look through to the holding periods of the underlying assets held by the partnership. Rather, as a starting point the holding period of the partnership interest is considered to determine whether the extended three-year holding period requirement is met. However, the Proposed Regulations do contain a look-through rule that generally applies if at least 80 percent of the value of the assets of the partnership are assets that would fail the extended three-year holding period requirement if disposed of by the partnership.
In addition, under a technical reading of the statutory language of Section 1061, certain amounts that are treated as long-term capital gain subject to preferential rates are not treated by the Proposed Regulations as subject to potential recharacterization. Gains from dispositions of depreciable property and real estate used in a trade or business, dividends, certain options and contracts marked to market on an annual basis, and certain straddle positions are all excluded from potential recharacterization. The conclusion of the Proposed Regulations with respect to real estate used in a trade or business may be a particular boon to managers of certain real estate-focused investment funds.
The Proposed Regulations further make clear that once a partnership interest is subject to Section 1061, its status cannot be cleansed by the original holder ceasing to provide services to the partnership or transferring the interest to another holder that does not provide services. A partnership interest thus generally will continue to be subject to Section 1061 until a specified exception applies. In furtherance of this approach, the Proposed Regulations include a new exception not contained in the statutory language for a "bona fide purchaser" that 1) acquires the interest for fair market value, 2) has not provided services to the partnership in the past, 3) does not contemplate providing services in the future, and 4) is not related to the holder or any other current or prior service provider. Similar to the treatment of the partnership interest itself, property distributed with respect to a partnership interest subject to Section 1061 remains subject to Section 1061 in the hands of the holder.
In addition, any installment sale gain that is recognized after the applicability date of Section 1061 is subject to the provisions of Section 1061, notwithstanding the fact that the disposition to which the gain relates occurred when Section 1061 was not applicable. The Proposed Regulations also provide that, solely for purposes of Section 1061, any derivative that has value by reference to a partnership (including the amount of partnership distributions, the value of partnership assets or the results of partnership operations) will be treated the same as an interest in the partnership.
Significant guidance is provided in the Proposed Regulations with respect to the scope of certain exceptions enumerated in Section 1061. Section 1061 provides that it does not apply to 1) any partnership interest directly or indirectly held by a corporation, and 2) capital interests.
Certain stakeholders had hoped to avail themselves of the corporate exception to largely sidestep the application of Section 1061 under certain structures. An entity classified as a "C corporation" under the Internal Revenue Code does not enjoy a reduced rate of taxation on long-term capital gains, and is also a taxpayer that will pay tax separate and apart from its ultimate direct or indirect individual owners. However, other classifications exist under the Internal Revenue Code that may treat an entity as both a "corporation" and subject to pass-through treatment with respect to the income it earns. On March 19, 2018, the IRS issued Notice 2018-18, stating its intention to promulgate regulations to exclude S corporations, which generally provide pass-through treatment to their owners, from the ambit of the corporate exception. The recent Proposed Regulations further make clear that passive foreign investment companies that have made a qualified electing fund election, which results in income being passed through to its electing owners on a current basis, are also excluded from the exception. Unlike other provisions of the Proposed Regulations, these exclusions will be retroactive if and when finalized. The exclusion of S corporations will be retroactive to the applicability date of Section 1061, consistent with statements made in Notice 2018-18. The exclusion of qualified electing funds is proposed to be retroactive to taxable years beginning after the date of publication of the Proposed Regulations in the Federal Register.
The Proposed Regulations also contain provisions to make clear that unrealized gain or loss with respect to a targeted partnership interest does not become gain or loss with respect to a capital interest by contributing the partnership interest to a new partnership prior to realization. To determine the amount of unrealized gain or loss in a targeted partnership interest, the Proposed Regulations require the partnership to consider the allocations that would occur to the holder on a taxable disposition of all of its underlying property under the capital account revaluation rules. Revaluation accounting may be a significantly burdensome exercise, particularly where there are tiers of partnerships, and the Proposed Regulations provide that a partnership required to revalue its capital accounts for purposes of Section 1061 may leave such capital accounts revalued for other purposes. The Proposed Regulations also require a partnership to apply principles applicable to contributions of built-in gain property to allocate gains subject to Section 1061 to the contributing partner. Where a holder directly or indirectly has both a capital interest eligible for the exception and a non-capital interest subject to Section 1061, complicated rules and requirements apply to separate excepted income from income subject to Section 1061.
The IRS declined to exercise the regulatory authority delegated to it under Section 1061 to provide a further exception in connection with proprietary investment activity not done on behalf of third parties, concluding that the existing exception for capital interests and related Proposed Regulations are sufficient to cover the same circumstances.
While certain holding company structures attempting to fit under the corporate holder exception are explicitly foreclosed by the Proposed Regulations, the treatment of certain other planning alternatives is left open. Specifically, the preamble to the Proposed Regulations acknowledges that parties may attempt to include the ability to "waive" the right to gains that would be subject to Section 1061, substituting instead allocations of gain that are outside of Section 1061 (e.g., dividends subject to the same reduced long-term capital gains rate). The IRS declined to include any provisions in the Proposed Regulations specifically directed at these and other similar arrangements, but states in the preamble that such allocations remain subject to preexisting anti-abuse provisions in the Internal Revenue Code, including substance over form. While exemplary preexisting anti-abuse provisions are enumerated, the preamble does not go on to state that such arrangements will always be invalid, only stating that they "may not" be respected.
Another area of lingering uncertainty is the precise universe of investment-type businesses that are captured by Section 1061. As stated above, the provision applies to recipients of partnership interests in exchange for services rendered to a business engaged in investing in or developing certain specified assets. As confirmed by the Proposed Regulations, shares of stock in a corporation are always a specified asset. However, interests in a partnership are not universally captured as a specified asset. Until there are rulings and case law as to specific taxpayers, there may be some continuing uncertainty as to whether investments in and development of businesses operated in partnership form are captured investment-type businesses under Section 1061.
The Proposed Regulations set forth significant reporting requirements on partnerships and holders. These reporting requirements extend as well to lower-tier partnerships that unknowingly are generating income that may be allocated to an indirect holder subject to Section 1061. It is expected that, once finalized, these reporting requirements will be addressed in whole or in part through the promulgation of new or amendment of existing IRS forms.
Finally, in acknowledgement of the burdensome calculation and reporting requirements imposed by certain aspects of the Proposed Regulations, the preamble requests comments for any simplified or alternative methods that may be made available to smaller partnerships that issue interests subject to Section 1061. This is a welcome invitation, and perhaps a prelude to some relief being afforded to partnerships with relatively fewer funds available to expend on tax advisors.
For more information or questions on the Proposed Regulations, contact the authors.
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