On January 7, 2021, the IRS and Treasury Department issued final regulations (T.D. 9945) under Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”, and such regulations, the “Final Regulations”) detailing, among other things, how long-term capital gain may be recharacterized as short-term capital gain in respect of carried interest arrangements of private equity funds (“Funds”). The IRS has generally adopted the structure and approach established by the proposed regulations ([REG-107213-18]) issued in August 2020 (the “Proposed Regulations”). However, the Final Regulations include a number of taxpayer-friendly changes to the Proposed Regulations. Please see our prior discussion of Code Section 1061 and the Proposed Regulations. The following discussion highlights the changes to the Proposed Regulations most relevant to Funds and their sponsors (“General Partners”).
Relaxed Capital Interest Exception and Related Rules
As discussed in more detail in our prior analysis of the Proposed Regulations and below, certain capital gains recognized by a General Partner in respect of its funded capital contributions (a “Capital Interest”) are generally eligible for a limited exception to short-term recharacterization under the 3-Year Holding Period Rules of Code Section 1061 (the “Capital Interest Exception”). The Final Regulations relax the requirements for the Capital Interest Exception that were previously proposed. Specifically, a General Partner will qualify for the Capital Interest Exception if the capital account allocations made to the General Partner in respect of its Capital Interest are determined and calculated in a manner similar to allocations on funded capital contributions of significant unrelated limited partners (i.e., non-service provider limited partners holding 5% or more of the aggregate capital of the Fund at the time the allocations are made). Importantly, the Final Regulations also clarify that certain terms of a General Partner’s Capital Interest that are typically different from a limited partner’s interest will not disqualify the General Partner from the Capital Interest Exception. Examples of such distinguishing terms include an entitlement to tax distributions and no charges for management fees or carried interest. However, the carried interest “earned” by a General Partner in respect of its Capital Interest, regardless of whether such carry is explicitly described as such in a Fund’s distribution waterfall, seems ineligible for the Capital Interest Exception based on an example included in the Final Regulations.
In addition, the Final Regulations require that Capital Interest allocations to the General Partner must be clearly identified in the Fund’s partnership agreement and books and records. As a result of these technical requirements, it would be prudent for General Partners to review their Fund and General Partner partnership agreements’ capital account allocation provisions to ensure the availability of the Capital Interest Exception for existing Funds.
The Final Regulations specify that the Capital Interest Exception applies in tiered partnership structures—thus a Capital Interest allocation from a lower-tier partnership (e.g., a private Fund) to an upper-tier partnership (e.g., the General Partner) will retain its character and qualify for the exception, provided allocations at the upper-tier partnership level are consistent with common partnership tax accounting requirements.
Lastly, the Final Regulations now permit individual members of the General Partner who fund their capital interests with a loan from another partner in the Fund (or related person to that partner other than the Fund) to benefit from the Capital Interest Exception so long as the individual remains personally liable for such loan. This departure by the Final Regulations from the more restrictive borrowed capital provisions of the Proposed Regulations is another helpful change for General Partners and their investment professionals.
Narrower Consequences for Certain Related Party Transfers
As discussed in more detail in our prior post, the Proposed Regulations suggested that certain transfers of a General Partner interest to a related party could potentially accelerate the recognition of capital gain. The Final Regulations clarify that, with respect to a direct or indirect transfer of a General Partner interest to a related person (generally, a family member or a co-worker that has performed services for the relevant Fund business), Code Section 1061 is merely a recharacterization rule and does not trigger immediate income recognition in an otherwise nontaxable transfer. This is a welcome modification that avoids income acceleration in non-abusive General Partner realignments and restructurings, estate planning and other transactions.
Other Notable Points
- The Final Regulations limit application of the look-through rule, which could recharacterize long-term gain recognized in a taxable disposition of a General Partner interest as short-term gain, to situations where, at the time of the disposition, (i) the 3-Year Holding Period Rules would not be satisfied if the holding period of such General Partner interest were determined by disregarding the period prior to the date on which unrelated limited partners of the Fund are first obligated to fund capital commitments, or (ii) one or more transactions have taken place with a principal purpose of avoiding recharacterization under Code Section 1061.
- The Final Regulations follow the Proposed Regulations in providing that unrealized capital gains with respect to a General Partner’s carried interest remain subject to Code Section 1061, and clarify that recharacterization as Capital Interest may apply to the extent that long-term capital gain (calculated prior to the application of Section 1061) allocated to the General Partner is reinvested in the Fund (either as the result of an actual distribution and recontribution of such amount or the retention of such amount by the Fund) to create a Capital Interest eligible for the Capital Interest Exception.
- The Final Regulations clarify certain reporting requirements and recharacterization mechanics applicable to certain passive foreign investment companies (“PFICs”) for which shareholders have qualified electing fund elections in effect.
- As with the Proposed Regulations, the Final Regulations do not shed new light on how the IRS intends to treat carried interest deferral or waiver arrangements commonly utilized by Funds and their General Partners to meet the 3-Year Holding Period Rules.
The Final Regulations generally apply to taxable years beginning on or after the date they are filed for public inspection in the Federal Register (subject to certain exceptions for S corporations and PFICs), and may be relied on by taxpayers for any taxable year beginning after December 31, 2017, provided that such Final Regulations are consistently applied in their entirety to such year and all subsequent years. While the Final Regulations have been submitted to the Office of the Federal Register, a publication date has not yet been scheduled.
Although the Final Regulations include many clarifications to the Proposed Regulations, they remain complicated and Treasury continues to ask for feedback and comments. As such, it is possible that additional regulatory guidance will be issued in the future.