On January 7, 2021, the Department of Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) released Final Regulations that provide guidance under Section 1061 of the Internal Revenue Code (“IRC”). The Final Regulations contain certain changes to the rules included under the previously released Proposed Regulations. Section 1061, a product of the Tax Cuts and Jobs Act of 2017 (the “TCJA”), constituted a Congressional response to those who have argued for an increased tax rate on gains recognized from certain profits interests, often referred to as carried interests, in a partnership. Prior to the TCJA, such interests were taxed at the long-term capital gains tax rate (currently 15 percent or 20 percent, depending on a taxpayer’s tax bracket, plus the 3.8 percent net investment income tax), if held for more than one year. Following the enactment of the TCJA, Section 1061 requires a holding period of more than three years for carried interests, defined as Applicable Partnership Interests, to receive the preferential long-term capital gains tax rate. Otherwise, gains resulting from such Applicable Partnership Interests will produce short-term capital gains taxed at ordinary tax rates (current top marginal tax rate is 37 percent). This FGMK Tax Alert provides an overview of the Final Regulations, focusing on changes from the Proposed Regulations, and exploring their potential impact. For a discussion of the Proposed Regulations, please read FGMK’s prior Tax Alert.
Section 1061 Overview
Section 1061(a) lengthens the required holding period of an Applicable Partnership Interest (“API”) from more than one year to more than three years for such interest to produce long-term capital gain. Section 1061(c) defines API to be a partnership interest that a taxpayer receives in exchange for performing substantial specified services for such issuing partnership entity, i.e., a carried interest, often referred to as a profits interest. The carried interest is any interest in a partnership which is, directly or indirectly, transferred to a taxpayer or a passthrough entity in the connection with the performance by the taxpayer, or a person related to the taxpayer, of an Applicable Trade or Business (“ATB”). An ATB arises from the combined activities of the taxpayer and/or related persons in either “Raising or Returning Capital” or “Investing or Developing Actions” undertaken with respect to certain “Specified Assets”.1
Overview of the Final Regulations
The Final Regulations elaborate on the meaning of an API and ATB in several ways. First, to be an API, the taxpayer must provide substantial services on a regular, continuous and substantial basis, which is defined as activities rising to the level of a trade or business under Section 162.2 The Final Regulations explain that where a taxpayer provides services in an ATB and receives a partnership interest, the services are presumed to be substantial.
Second, the Final Regulations elaborate on the definitions of “Raising or Returning Capital” and “Investing in Development Actions” (collectively the “Specified Actions”). Raising or Returning Capital means soliciting investors and raising capital for investment.3 Investing in Development Actions means either investing in or disposing of certain Specified Assets or developing such Specified Assets.
Third, an ATB can be established not only through acts undertaken directly by the taxpayer, but also through acts taken by parties related to the taxpayer.4 Specifically, the collective actions, if undertaken by the taxpayer and any other individuals or entities related to the taxpayer, will be considered in aggregate to determine whether such activities constitute an ATB.5
Finally, under the Final Regulations it is now necessary that an API Holder (as defined below), either directly or through related entities, conducts both Specified Actions in order to satisfy the ATB Activity Test.6 Under the Proposed Regulations, it was not necessary that the API Holder perform both Specified Actions.7 The Final Regulations provide that an API Holder must perform both, however, this relief is minimal at best. First, the activities of all individuals or entities related to the taxpayer are considered in determining whether the ATB test is met.8 Second, the IRS and Treasury declined commenter requests to raise the standard for what constitutes Raising or Returning Capital, thus virtually any action undertaken by an API Holder to raise capital will meet this standard.9 Third, it is not necessary that an API Holder (including related parties), perform both Specified Actions in the same tax year for the ATB Activity Test to be met.10
For example, if in 2020, a taxpayer undertakes an action to raise capital for a new fund and receives an interest in the partnership as compensation, and then, in 2021, the taxpayer raises more capital while a Management Company owned by the taxpayer’s spouse takes action to invest in and develop Specified Assets, the collective actions of the taxpayer and the Management Company, which is related to the taxpayer, constitute an ATB, despite the fact that no Investment or Development Actions were undertaken in 2020.11 Moreover, it is not necessary that the taxpayer perform any actions related to their interest for such interest to be deemed an API. As an example, if a taxpayer receives a partnership interest and a party related to the taxpayer performs services rising to the level of an ATB for the partnership, the interest received by taxpayer is an API, despite the taxpayer’s lack of providing any services.12 Ultimately, taxpayers will need to consider numerous factors and issues in determining whether they have an ATB with respect to a received partnership interest.
Additional Exclusions from API
The Final Regulations remind taxpayers that Section 1061 only applies to capital gains and losses under Section 1222. Any gains or losses which are taxed at capital gains rates, but which are not actually capital gains under such Section 1222, are excluded from Section 1061.13 Specific examples include gains and losses under Section 1231 (relating to property used in a trade or business), Section 1256 (relating to regulated futures, currency, or other certain contracts), and Section 1(h)(11)(B) (relating to qualified dividends taxed at long-term capital rates).14
The Final Regulations affirm this treatment by rejecting comments calling for the inclusion of Section 1231 gains under Section 1061.15 This is a particularly pertinent exception for the real estate industry, as any building managed as a trade or business is considered Section 1231 property and is therefore excluded from application of Section 1061. Additionally, the Final Regulations provide a change under which gains from the distribution of property to an API Holder will not fall under Section 1061 to the extent such property is otherwise excluded property (e.g., Section 1231 property).16 This is a welcome change from the Proposed Regulations, under which it appeared the distribution of such property to an API Holder might still fall within the parameters of Section 1061. However, the Final Regulations confirm that gain from the sale of an API will be subject to Section 1061 as a capital gain arising under Section 1222, even if the assets of the API constitute Section 1231 assets, since the sale of or exchange of a partnership interest is the sale or exchange of a capital asset pursuant to Section 741 (except as otherwise provided in Section 751 relating to unrecognized receivables and inventory items).17
Additionally, gains and losses taxed as capital under Section 1222 are still excluded from application of Section 1061 if they constitute Capital Interest Allocations.18 While the Proposed Regulations excluded certain gains for partnerships electing to fall under an included transition rule, the Final Regulations eliminate the transition rule based on feedback from commenters and the determination that such a rule is unnecessary.19
Gains and losses will constitute Capital Interest Allocations if such gains and losses are allocated to the taxpayer based on their relative capital accounts and are made in the same manner to all similarly situated Unrelated Non-Service Partners who have made significant aggregate capital contributions.20 This is a significant change from the Proposed Regulations, which had a more stringent rule with respect to Capital Interest Allocations.21 The Proposed Regulations required that allocations to the API Holder had to be made in the same manner to the API Holder as to all other partners, based on IRC Section 704(b) allocations.22 Commenters criticized this rule, pointing out that practically many partnerships do not allocate under the Section 704(b) rules (e.g., many partnerships use targeted allocations), and that requiring such a high standard would effectively preclude many API Holders from utilizing this rule even if they had, in fact, contributed capital to a partnership.23 Treasury and the IRS ultimately agreed with this critique, and modified the Final Regulations to provide for a more lenient rule.24
While there is significant complexity surrounding this rule, it is stated simply as follows: if a taxpayer contributed capital to a partnership, and receives allocations of gain or loss based on such contribution, those allocations are not subject to Section 1061, so long as other similarly situated partners who are not service partners in the partnership receive allocations based on their capital contributions in a comparable fashion.
An Unrelated Non-Service Partner is any partner who does not perform services for the partnership as long as they have made a “significant aggregate capital contribution”, defined as at least five percent of the capital of the partnership at the time of the contribution.25 Allocations will be made in a similar manner if they are made in a way which is “reasonably consistent with allocation and distribution rights related to capital of an Unrelated Non-Service Partner.26 Factors to consider when determining whether an allocation is “reasonably consistent” include, but are not limited to, the amount and timing of capital contributed, the rate of return on capital contributed, the terms, priority, type, and level of risk associated with capital contributed, and the rights to cash or property distributions during the partnership’s operations and on liquidation.27 However, the Final Regulations make clear that a Capital Interest Allocation will not fail simply because amounts received by the API Holder are not reduced by management fees or other costs of service paid to the API Holder (or related person), or because the API Holder has certain rights, such as the right to receive tax distributions, which Unrelated Non-Service Partners do not possess.28 Nonetheless, Capital Interest Allocations will not be respected unless such allocations are clearly identified in the partnership agreement and in the partnership’s books as separate and distinct from allocations unrelated to capital contributions.29 Finally, if an API Holder contributes capital using proceeds, either directly or indirectly, from a loan made to such API Holder by the partnership a partner in the partnership, or any related person with respect to such persons, it is not a Capital Interest Allocation.30 An exception to this general rule allows the proceeds of a loan from another partner to be used to create a capital interest, however, so long as the API Holder partner is personally liable on the loan to such other partner.31
As an example, if a taxpayer contributes $300 to a partnership, equivalent to 2 percent of the total capital of the partnership and receives an allocation $160 out of $8,000 of total long-term capital gain recognized by the partnership, then the $160 of gain is a Capital Interest Allocation, assuming the remaining $7,840 of gain is allocated to the remaining 98 percent of the other, unrelated capital partners.32 However, if the same taxpayer, in exchange for services constituting an ATB, also receives an allocation of 20 percent of the net profits of the partnership, such amount is subject to Section 1061, because the taxpayer’s interest is an API and the allocation is made without regard to the taxpayer’s capital account (which, in this example, is only equivalent to two percent of the total capital of the partnership).33
Assuming no exceptions apply, capital gains and losses allocated to an API Holder will be subject to Section 1061 and the more than three-year hold rule for long-term capital gain treatment. The specifics of the calculation are convoluted when read, but ultimately look to the excess of gains from assets held for three years or less over gains from assets held for more than three years.34 In determining the amount of gain being considered, the Owner Taxpayer must consider both allocations of gain received from an API interest (“Distributive Share Amounts”), as well as gains from the disposition of an API interest itself, in whole or in part (“Disposition Amounts).35 The Final Regulations include a narrow exception to this general rule as it pertains to an Owner Taxpayer’s disposition of an API to an unrelated person referred to as the “Lookthrough Rule”.36 The Final Regulations significantly modify the application of the Lookthrough Rule from its form under the Proposed Regulations, applying it in only two situations: when an API would have a holding period of three years or less if any period prior to the first legally required capital substantial capital contribution by an Unrelated Non-Service Partner is disregarded, or if there is a transaction or series of transactions the principal purpose of which is to avoid the application of Section 1061.37 A legally required capital contribution is considered substantial if it is equal to or greater than five percent of the API’s total assets at the time of the API Holder’s disposition of the interest.38 If an Owner Taxpayer disposes of an API held for more than three years, but either of the above situations apply to the API, then a portion of the gain recognized by the Owner Taxpayer on such disposition will be recharacterized as short-term capital gain under Section 1061.39 Therefore, if an Owner Taxpayer sells an API, but 90 percent of the assets of the API partnership were only contributed by reason of a legal requirement within the past year, then the API Holder will be forced to recognize short-term capital gain under Section 1061 in the amount of their interest in the profits of the partnership under the partnership agreement.40 This is a substantial change from the Proposed Regulations which used a “Substantially All” test that looked to the overall percentage of assets held by the API for less than three years for determining applicability of the Lookthrough test.41
The other exception is contained in Section 1061(d) which provides that the transfer of an API by an Owner Taxpayer to a related person will result in the Owner Taxpayer including in income as short-term capital gain the excess of long-term capital gains from assets held by the partnership for less than three years (the “1061(d) Amount”) over any amounts treated as short-term capital gains by virtue of the normal operation of Section 1061 and the regulations thereunder.42 The 1061(d) Amount is the amount of gain which would have been allocated to the Owner Taxpayer had all of the assets of the API partnership been sold in a fully taxable transaction immediately prior to the transfer.43 The Final Regulations provided a significant change to Section 1061(d), limiting its application only to transfers to related persons in which gain is recognized.44 Under the Proposed Regulations, Section 1061(d) was also applied to nonrecognition transactions, such as contributions, distributions, sales and exchanges, and gifts.45 The Final Regulations only require the Section 1061(d) inclusion to the extent that gain is recognized upon the transfer to a related person.46 For purposes of this exception, a “related person” is determined under special rules specific to Section 1061(d).47 Specifically, for purposes of Section 1061(d), a related person is: (1) a member of the Owner Taxpayer’s family per Section 318 (spouse, parent, child, or grandchild), (2) a person that performed a service within the current calendar year or preceding three calendar years related to an ATB for an API transferred by the Owner Taxpayer, i.e., current or former colleague, or (3) a passthrough entity owned, directly or indirectly, by either the Owner Taxpayer or a person related to the Owner Taxpayer under the Final Regulations.48
Ultimately, the Final Regulations are reasonably taxpayer friendly, particularly for taxpayers engaged in the real property trade or business. The exclusion of Section 1231 gains from the application of Section 1061 is a massive exception for the real estate industry and should effectively remove managed real estate funds from the umbrella of Section 1061 in many instances. Further, the liberalized definition of a Capital Interest is likely beneficial to API Holders in partnerships which do not use Section 704(b) allocations. Additionally, the modified Lookthrough Rule is likely taxpayer favorable, as the composition of assets is no longer automatically determinative as to whether the rule will apply. That being said, API Holders must now pay greater attention to the timing of major capital contributions, and not just their holding period for the API in order to determine whether the Lookthrough Rule will apply.
Treasury and IRS reserved the right to consider additional issues and may issue more regulations if they determine it to be appropriate. Of particular note is the Final Regulation’s failure to issue any rules with respect to Section 1061(b), which provides that the rules of Section 1061 will not apply to gains related to assets not held for portfolio investment on behalf of third-party investors. Commenters had requested guidance on this rule, particularly as it might relate to certain family offices. Treasury and the IRS instead stated in the preamble that they believe that the modified Capital Interest and Lookthrough rules generally addressed these concerns, but that they would continue to research the issue further.49
Taxpayers consult with their tax advisor to determine to what extent they might otherwise be impacted by these Final Regulations. The Final Regulations are extremely complex, and the difference between having Section 1061 apply to recharacterize gains and falling under an exception may be significant. Impacted taxpayers, working with their tax advisor, should quickly determine whether any potential planning opportunities exist with respect to any existing or anticipated APIs.
Please contact FGMK if you have additional questions regarding these Final Regulations.
2Treas. Reg. §1.1061-2(b)(1)(i)
3Treas. Reg. §1.1061-1(a)
4Treas. Reg. §1.1061-2(b)(1)(i)(C)(1)
6Treas. Reg. §1.1061-2(b)(1)
7Treas. Reg. §1.1061-2(b)(1)(i)(C)
9T.D. 9945 pg. 53 (2021)
10Treas. Reg. §1.1061-2(b)(1)(i)(B)
11See Treas. Reg. §1.1061-2(b)(2) Examples 1-6
12Treas. Reg. §1.1061-2(a)(1)(iv); Treas. Reg. §1.1061-2(a)(2)(v) Example 5.
13Treas. Reg. §1.1061-4(b)(7)
15T.D. 9954 pg. 74-76 (2021)
16Treas. Reg. §1.1061-4(a)(4)(i)(C)
17T.D. 9954 pg. 76-78 (2021)
18Treas. Reg. §1.1061-3(c)(3)
19T.D. 9945 pg. 80 (2021)
20Treas. Reg. §1.1061-4(c)(3)(i)
21See Prop. Treas. Reg. §1.1061-4(c)(6)
23T.D. 9954 pg. 14 (2021)
24T.D. 9954 pg. 17(2021)
25Treas. Reg. §1.1061-3(c)(3)(iv)
26Treas. Reg. §1.1061-3(c)(3)(ii)
27Treas. Reg. §1.1061-3(c)(3)(ii)(A)
28Treas. Reg. §1.1061-3(c)(3)(A)
29Treas. Reg. §1.1061-3(c)(3)(ii)(B)
30Treas. Reg. §1.1061-3(c)(3)(v)(A) (A recent Tax Notes article, Carried Interest rules May Contain Glitch for Some Borrowers, contains commentary that notes that the Final Regulations remove the words “any other” from before the word “partner”, and thus the service partner who borrows from a related party may not have use of the capital interest allocation rule)
31Treas. Reg. §1.1061-3(c)(3)(v)(B)
32See Treas. Reg. §1.1061-3(c)(6) Example 1
34See Treas. Reg. §1.1061-4(a)(1)
35See Treas. Reg. §1.1061-4(a)(4)
36Treas. Reg. §1.1061-4(b)(9)
37Treas. Reg. §1.1061-4(b)(9)(i)(A)
38Treas. Reg. §1.1061-4(b)(9)(i)(A)(1)
39Treas. Reg. §1.1061-4(b)(9)(ii)
40See Treas. Reg. §1.1061-4(c)(2)(i) Example 1
41See Prop. Treas. Reg. §1.1061-4(b)(9)
43Treas. Reg. §1.1061-5(c)
44T.D. 9954 pg. 40-14 (2021)
45Prop. Treas. Reg. §1.1061-5(b)
46Treas. Reg. §1.1061-5(c)
47Treas. Reg. §1.1061-1(a)
48Treas. Reg. §1.1061-5(e)
49T.D. 9945 pg. 85-87 (2021)
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.
FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For over 50 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.