On Friday, July 31, 2020, the Department of Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) released Proposed Regulations that provide guidance under Section 1061 of the Internal Revenue Code (“IRC”). Section 1061, a product of the Tax Cuts and Jobs Act of 2019 (the “TCJA”), constituted a Congressional response to those who 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, all 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 passage of the TCJA, Section 1061 requires a longer hold period of more than three years for carried interests, defined as Applicable Partnership Interests, to receive the preferential capital gains tax rate. Otherwise, gains resulting from such Applicable Partnership Interests will produce short-term capital gains taxed at ordinary gain rates (current top marginal tax rate is 37 percent). This FGMK Tax Alert provides an overview of the newly released Proposed Regulations and their potential impact.
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 interests to produce long-term capital gain. Section 1061(c) defines API to be a partnership interest that a taxpayer receives in exchange for performing certain specified services for such issuing partnership entity, i.e., a carried interest, often referred to as a profits interest. The carried interest is held in connection with the performance of services for the issuing partnership, specifically the conduct of a trade or business focused on raising capital to invest in specified assets which include certain securities and commodities, cash or cash equivalents, real estate held for rental or investment, and an interest in a partnership to the extent the partnership holds a specified asset.
An API is a partnership interest received by a taxpayer in exchange for the performance of substantial services for the partnership. More specifically, this includes 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”. Specified Assets include securities, commodities, real estate held for investment, cash or cash equivalents, and an interest in a partnership to the extent such partnership holds Specified Assets.
Section 1061(c)(4) set forth exceptions to the term API, including any interest in a partnership directly or indirectly held by a corporation. Due to some initial thoughts that the term “corporation” may include S-corporations, some taxpayers considered modifying investment structures. However, on March 19, 2018, the IRS issued Notice 2018-18 which provided notice that the regulations under Section 1061 would define “corporation” in a manner to exclude S-corporations.
The Proposed Regulations now set forth guidance with respect to the application of the holding period to respective partnership interests and property held by such partnerships.
Overview of the Proposed Regulations
The Proposed Regulations elaborate on the meaning of an API and ATB in several ways. First, to be an API, the taxpayer must be providing 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. The Proposed 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 Proposed Regulations elaborate on the definitions of “Raising or Returning Capital” and “Investing or Developing Actions”. Raising or Returning Capital means soliciting investors and raising capital for investment. Investing or Developing Actions means either investing in or disposing of certain Specified Assets or developing such Specified Assets. A taxpayer or related person is deemed to have developed Specified Assets if they have represented to investors and other interested parties that the taxpayer will enhance the value of such assets through direct choices and actions of the taxpayer. However, a taxpayer merely exercising voting rights with respect to owned shares of stock does not constitute a development action.
Third, an ATB can be established both through acts undertaken directly by the taxpayer, as well as acts taken by parties related to the taxpayer. Specifically, the collective actions, in either Raising or Returning Capital or Investing or Developing Actions 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. Related Persons include any person or entity related to the taxpayer under Sections 707(b) or 267(b). Additionally, actions undertaken by an agent or delegate of the taxpayer or a related person will be taken into account as if undertaken by the taxpayer and/or related person.
Finally, it is not necessary that all parties perform both Raising or Returning Capital or Investing or Developing Actions, or that both actions are undertaken every year. For example, if in 2020 a taxpayer undertakes 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 Specific 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 Investing or Developing Actions were undertaken in 2020. What’s more, it is not necessary the taxpayer perform any actions related to their interest for such interest to be deemed an API. For 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. Ultimately, taxpayers will need to consider numerous factors and issues in determining whether they have an ATB with respect to a received partnership interest.
Even if an interest in a partnership is received prior to a level of services constituting an ATB is reached, the aggregate approach will look at all the actions undertaken by a taxpayer and/or related person from receipt onward, and, once the services rise to the level of an ATB, the partnership interest is deemed an API. Additionally, once such interest becomes an API, that character remains, even if the taxpayer ceases to perform services rising to the level of an ATB. Any unrecognized gains and losses of assets attributable to the API retain their character of API Gains and Losses subject to the three year rule of Section 1061.
The Proposed Regulations reiterate the government position that holders of an API include a “Passthrough Entity”, defined to include a partnership, S-corporation, or a passive foreign investment company (“PFIC”) with a qualified electing fund (“QEF”) election. Grantor trusts, qualified subchapter S subsidiaries (“QSSS”), and single owner disregarded entities (e.g., single member LLC) are disregarded for purposes of applying Section 1061 and the regulations thereunder.
The Proposed Regulations explain that PFIC shareholders may avoid the application of Section 1061 where they otherwise have the benefit of passthrough tax treatment on income from such an entity for a taxable year. The exclusion of S corporations and PFICs with a QEF election from the Section 1061(c)(4) corporation exception represent Treasury’s exercise of authority for issuing regulations as necessary to carry out the purposes of Section 1061 as provided in Section 1061(f).
Additional Exclusions from API
The Proposed 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 are not actually capital gains under such Section 1222, are excluded from Section 1061. 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). 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. However, it seems likely that if an API partnership distributed Section 1231 property to an Owner Taxpayer, who in turn sold the Section 1231 property for a gain, such gain would fall under Section 1061. Though allocated Section 1231 gains are excluded, gains from the sale of an Owner Taxpayer’s API interest do fall under Section 1061, included gains on the sale of Distributed API Property to the Owner Taxpayer by the API partnership. Distributed API Property is any property distributed by the API partnership (or upper tier Passthrough Entity) to an Owner Taxpayer. No exception is provided for property which is not a capital asset under Section 1222.
Additionally, gains and losses taxed as capital under Section 1222 are still excluded from application of Section 1061 if they either fall under the Partnership Transition Rule or constitute Capital Interest Allocations.
First, the Proposed Regulations provide for a Partnership Transition Rule for partnerships which were in existence prior to the enactment of the TCJA. Under this transition rule, a partnership may elect to treat all gains arising from assets held for at least three years prior to January 1, 2018 as “Partnership Transition Gains”. Such gains are fully excluded from the API recharacterization determination and are taxed as long-term capital gains in the year recognized. This rule allows partnerships who did not closely track Section 1061 issues prior to its existence to simplify gains arising from pre-Section 1061 assets into an excluded class of gain. In order to take advantage of Partnership Transition Rule, partnerships must make an irrevocable election in the year that the gains are recognized.
Secondly, and more broadly, gains and losses will constitute Capital Interest Allocations if such gains and losses are allocated to the taxpayer based on their relative capital account and are made in the same manner to all partners. 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 all other partners in the partnership receive allocations based on their capital contributions as well.
For 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% of the other, unrelated capital partners. 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 2 percent of the total capital of the partnership).
Additional rules exist for API interest held by the taxpayer indirectly through one or more passthrough entities, depending on how the intermediate passthrough entities allocate the Capital Interest Allocation from the API. Rules also exist to determine how much of the gain from the disposition of an API should be considered to be a Capital Interest Allocation versus gain or loss subject to Section 1061. All these rules contain significant complexity, but all turn on the basic premise that the excluded allocation of gain or loss must be made based on a pro rata distribution to partners based on capital accounts. Only those allocations made based on a partner’s direct or indirect contribution of capital which are made to a significant number of other partners in the same fashion will qualify. It should be noted, however, that the Proposed Regulations do not address whether a Capital Interest Allocation qualifies if the Owner Taxpayer receives the allocation unreduced by the management fees and capital interest allocations received by the other partners. In that scenario, because the non-API have their allocations reduced by fees paid to the API interest holder in exchange for their services, it is unclear whether the gain allocations would be deemed “pro-rata” if the API holder’s allocation was not also reduced. Because of this uncertainty, as well as the general complexity of the Capital Interest Allocation rule in general, taxpayers should carefully consider whether allocations meet this narrow standard and ensure no inadvertent mistakes are made in the partnership agreement that would cause such allocations to fall out of this exception.
Finally, prior to the release of the Proposed Regulations, some believed that a taxpayer could convert an API into a capital interest by contributing the API into a passthrough entity in exchange for a limited partner interest therein, and taking a capital account in such passthrough based on the value of the contributed API. The Proposed Regulations reject this belief and hold that taxpayers who contribute an API must track unrecognized gain or loss from such API under principals similar to those of Section 704(c) and such amounts must retain the same character for purposes of Section 1061.
Assuming no exceptions apply, capital gains and losses allocated to an API Holder will be subject to Section 1061 and the 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 capital assets held for three years or less over gains from capital assets held for more than three years. In determining the amount of gain being considered, the Owner Taxpayer must consider both allocations of gain received from an API (“Distributive Share Amounts”), as well as gains from the disposition of an API itself, in whole or in part (“Disposition Amounts). In determining gains from Distributive Share Amounts, the taxpayer determines all gains and losses allocated to them under Sections 702 and 704, and then reduces such amounts by gains which are excluded from Section 1061, including Section 1231 gains, Section 1256 gains, and Partnership Transition Amounts. In determining gain or loss on the disposition of an API, the taxpayer generally follows the rules of Section 741 and the rest of subchapter K, but also includes gain recognized under the installment sale in the year recognized, gain or loss on the liquidation of an API under Section 731, gain or loss on the sale of a capital asset distributed to a taxpayer from an API (likely including gain from a Section 1231 asset which, if sold by the partnership directly, would not have been covered by Section 1061), and long-term capital gains or losses arising from the application of Section 751(b). This amount, however, is subject to a limited “Lookthrough Rule”, discussed below.
As the recharacterization amount is determined based on gains from property held less than three years and property held for more, the crucial question in determining whether capital gains or losses subject to Section 1061 are taxed as long-term or short-term capital gains is what the holding period of the disposed of asset is. The Proposed Regulations state that the holding period with respect to an asset is the direct owner’s holding period in such asset, and that the rules for determining how long an asset has been held are all relevant rules under the Internal Revenue Code and the regulations thereunder (generally time elapsed from the date the asset was acquired). For example, an Owner Taxpayer must look at the API partnership’s holding period for each asset generating gain to determine the correct treatment under Section 1061, but would look at their holding period for the API interest itself to determine treatment under Section 1061 upon disposition of the API. However, two exceptions exist with respect to an Owner Taxpayer’s direct disposition of an API.
First, the Proposed 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”. If an Owner Taxpayer disposes of an API held for three years or more, but “substantially all” of the capital assets of the API partnership are assets held for less than three years, 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. For purposes of this Lookthrough Rule, an API partnership is deemed to hold “substantially all” assets held for less than three years if at least eighty percent of the assets of the API partnership fall into such category, based on fair market value. If the Lookthrough Rule applies, then a percentage of the recognized gain equal to the three years or less assets held by the partnership is recharacterized as short-term capital gain under Section 1061. Therefore, if an Owner Taxpayer sells an API interest, that has been held for three years for a gain of $100,000, but 80 percent of the assets of the API partnership have been held for only two years, then eighty percent of the $100,000 of gain, or $80,000, will be recharacterized as short-term capital gain under Section 1061.
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 by virtue of the normal operation of Section 1061 and the regulations thereunder. The 1061(d) Amount is the amount of gains 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. Section 1061(d) applies to a wide variety of transfers, including, but not limited to, contributions, distributions, sales and exchanges, and gifts. For purposes of this exception, a “related person” is determined under special rules specific to Section 1061(d). Specifically, for purposes of Section 1061(d), a related person is: (1) a member of the 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 taxpayer, i.e. current or former colleague, or (3) a passthrough entity owned, directly or indirectly, by either the taxpayer or a person related to the taxpayer under the Proposed Regulations. However, this section does not apply to the contribution of an API into another partnership by the Owner Taxpayer, as such built-in gain would be subject to the Section 704(c) principles. This exception ensures that an Owner Taxpayer is not able to avoid the application of Section 1061, either by gifting their API or engaging in a bargain sale of the interest with a related party. This rule applies both to the direct transfer of an API interest, as well as an indirect transfer created by transferring an interest in a passthrough entity which, either directly or indirectly, holds an API.
Finally, the preamble to the Proposed Regulations cautions that certain specific allocations, in which the API holder waives their right to allocations of gain until assets have been held for three years or longer, or specifically is allocated only gains from assets with a three-year holding period may not be respected by the IRS. Such “carry waivers”, in the IRS’s opinion, likely run afoul of the Subchapter K substantial economic effect rules, as well as general tax doctrines of substance over form and economic substance. Though not addressed in the body of the Proposed Regulations, taxpayers should be on notice if contemplating such an arrangement.
Ultimately, the Proposed 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 with respect to the Distributive Share Amounts 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. Additionally, the narrow application of the Lookthrough Rule is taxpayer favorable, allowing the holder of an API to dispose of their interest at long-term rates after three years unless the high bar of “substantially all” is met. While the inclusion of an S Corporation under the definition of a “passthrough entity” is less favorable, given the IRS’s position in Notice 2018-18, it should hardly be surprising. The only significant rule cutting against taxpayers is the limited definition of a Capital Interest Allocation. Under these Proposed Regulations, only pro rata allocations will qualify for this exception, and taxpayers may have capital account-based allocations that still fail to meet this narrow definition and, as such, would not qualify for the exception.
Overall favorability or not, however, it is imperative taxpayers consult with their FGMK tax advisor to determine to what extent they might otherwise be impacted by these Proposed Regulations. The Proposed 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.
 IRC §1061(c)(3)
 Prop. Treas. Reg. §1.1061-2(b)(1)(i)
 Prop. Treas. Reg. §1.1061-1(a)
 Prop. Treas. Reg. §1.1061-2(b)(1)(i)(C)(1).
 Prop. Treas. Reg. §1.1061-1(a).
 Prop. Treas. Reg. §1.1061-2(b)(1)(i)(C)(2).
 Prop. Treas. Reg. §1.1061-2(b)(1)(i)(B).
 See Prop. Treas. Reg. §1.1061-2(b)(2) Examples 1-6.
 Prop. Treas. Reg. §1.1061-2(a)(1)(iv); Prop Treas. Reg. §1.1061-2(a)(2)(v) Example 5.
 See Prop. Treas. Reg. §1.1061-2(b)(2)(iii) Example 3.
 Prop. Treas. Reg. §1.1061-2(a)(1)(i).
 Prop. Treas. Reg. §1.1061-2(a)(ii).
 Prop. Treas. Reg. §1.1061-1(a).
 Prop. Treas. Reg. §1.1061-2(a)(1)(v).
 Prop. Treas. Reg. §1.1061-4(b)(6)(iv).
 Prop. Treas. Reg. §1.1061-4(b)(6).
 Prop. Treas. Reg. §1.1061-4(a)(4)(i)(C).
 Prop. Treas. Reg. §1.1061-1(a).
 See Id.
 Prop. Treas. Reg. §1.1061-4(c)(1).
 Prop. Treas. Reg. §1.1061-4(c)(3)(i).
 See Prop. Treas. Reg. §1.1061-4(c)(7)(i)(C) Example 1.
 See Prop. Treas. Reg. §1.1061-4(c)(5).
 See Prop. Treas. Reg. §1.1061-4(c)(6).
 Prop. Treas. Reg. §1.1061-2(a)(1)(ii)(B).
 See Prop. Treas. Reg. §1.1061-4(a)(1).
 See Prop. Treas. Reg. §1.1061-4(a)(4).
 Prop. Treas. Reg. §1.1061-4(a)(3)(i)(B).
 See Prop. Treas. Reg. §1.1061-4(a)(4)(i).
 Prop. Treas. Reg. §1.1061-4(b)(8)(ii).
 Prop. Treas. Reg. §1.1061-4(b)(8)(i).
 Prop. Treas. Reg. §1.1061-4(b)(9).
 Prop. Treas. Reg. §1.1061-4(b)(9)(C)(1).
 IRC §1061(d)(1)
 Prop. Treas. Reg. §1.1061-5(c)(1)(A).
 Prop. Treas. Reg. §1.1061-5(b).
 Prop. Treas. Reg. §1.1061-1(a)
 Prop. Treas. Reg. §1.1061-5(e).
 Prop. Treas. Reg. §1.1061-5(e)(2).
 Prop. Treas. Reg. §1.1061-5(c)(1)(B).
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