The Internal Revenue Service (IRS) recently issued proposed regulations under section 1061, a provision enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA) that recharacterizes certain net long-term capital gain with respect to « applicable partnership interests » as short-term capital gain (Note: All references to « section » are to the Internal Revenue Code of 1986, as amended (the « Code »), unless otherwise indicated). The proposed regulations provide clarity on some of the statutory provisions. The following discusses some of the noteworthy provisions in the proposed regulations.
Section 1061: In General
Section 1061 recharacterizes certain net long-term capital gain with respect to « applicable partnership interests » (APIs) as short-term capital gain. Specifically, if one or more APIs are held by a taxpayer at any time during the taxable year, the excess (if any) of (i) the taxpayer’s net long-term capital gain with respect to such interests for such taxable year, over (ii) the taxpayer’s net long-term capital gain with respect to such interests for such taxable year computed by applying a three-year holding period rather than the typical one-year holding period, is treated as short-term capital gain (the proposed regulations define this amount as the « Recharacterization Amount »). The Recharacterization Amount is taxed at short-term capital gains rates (currently the same as ordinary income rates) rather than preferential long-term capital gains rates.
An API is any interest in a partnership which, directly or indirectly, is transferred to (or is held by) a taxpayer (an « API Holder ») in connection with the performance of substantial services by that taxpayer, or any other related person, in any applicable trade or business (ATB).
There are a number of exceptions as to what constitutes an API, but generally it would include any carried interest held by a service provider to an investment fund. An API generally does not include: (i) an interest held by a person employed by another entity that is conducting a trade or business (other than an ATB) and only provides services to such other entity; (ii) any interest in a partnership directly or indirectly held by a corporation; or (iii) any capital interest in the partnership that provides a taxpayer with a right to share in partnership capital. An ATB is any business activity conducted on a regular, continuous and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of: (i) raising or returning capital; and (ii) either (A) investing in (or disposing of) « specified assets » (or identifying specified assets for such investing or disposition), or (B) developing specified assets. Generally, « specified assets » are securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing.
Once an API, Always an API
The proposed regulations provide that once a partnership interest is an API, it remains an API and never loses that character as such, unless one of the exceptions applies. This is the case even if: (i) the taxpayer or a related person ceases to provide services in an ATB; (ii) a partner retires and provides no further services so long as such partner continues to hold the partnership interest; (iii) a partner provides services but the ATB activity test is not met in a later year; or (iv) the API is contributed to another passthrough entity or a trust or is held by an estate.
Moreover, the proposed regulations provide that if an interest in a partnership is transferred to a « passthrough taxpayer » (e.g., an S corporation or an entity taxed as a partnership) in connection with the performance of its own services, the services of its owners, or the services of persons related to either the passthrough entity or its owners, the interest is an API as to the passthrough taxpayer.
Applicable Trade or Business (ATB)
The statute defines an ATB as any activity conducted on a regular, continuous and substantial basis which consists, in whole or in part, of raising or returning capital, and either: (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition); or (ii) developing specified assets.
The proposed regulations provide that an activity is conducted on a regular, continuous and substantial basis if the total level of activity (which can include one or more entities) meets the level of activity required to establish a trade or business for purposes of section 162. The proposed regulations further provide that the activities constituting an ATB do not necessarily need to occur during the same year for an ATB to exist for that year. Moreover, the proposed regulations allow for activities of related persons to be aggregated for purposes of determining whether an ATB exists.
The proposed regulations provide examples that demonstrate how the ATB test can be applied to a general partner (GP) in certain circumstances. In one example, a GP only conducts raising or returning capital actions, while a related management company conducts investing or developing actions. Because the activities of the GP and its related management company are aggregated, both are deemed to be engaged in an ATB and services performed by either of them are performed in an ATB. In another example, a GP cannot avoid being engaged in an ATB by simply delegating its management obligations to an unrelated management company.
Transfers of APIs to Related Persons
Section 1061(d) generally provides that if a taxpayer transfers an API to a related person, then the taxpayer is required to include in gross income as short-term capital gain the excess of (a) the net built-in long-term capital gain in assets attributable to the transferred interest with a holding period of three years or less, over (b) the amount of long-term capital gain treated as short-term capital gain under section 1061(a) at the time of the transfer. For purposes of section 1061(d), a related person includes members of a taxpayer’s family, the taxpayer’s colleagues who provide services in the applicable trade or business during certain specified time periods, and a passthrough entity to the extent a member of the taxpayer’s family or a colleague is an owner thereof.
The proposed regulations provide examples illustrating the mechanics of section 1061(d), including the following: A, an individual, performs services in an ATB and has held an API in connection with those services for 10 years. The API has a fair market value of $1,000 and a tax basis of $0. A transfers all of the API to A‘s daughter (a related person) as a gift. Immediately before the gift, if the partnership that issued the API had sold all of its assets for fair market value, then A would have been allocated $700 of net long-term capital gain from assets held by the partnership for three years or less. Therefore, the amount described in proposed regulation section 1.1061-5(a)(1) is $700. A did not recognize any gain on the transfer for federal income tax purposes before application of proposed regulation section 1.1061-5, which means that the amount described in proposed regulation section 1.1061-5(a)(2) is $0. A includes the difference between $700 and $0 in gross income as short-term capital gain. Thus, A includes $700 in gross income as short-term capital gain. A‘s daughter increases her basis in the API by the $700 of gain recognized by A on the transfer under proposed regulation section 1.1061-5(d).
The proposed regulations provide that gain is accelerated regardless of whether a transfer is otherwise taxable under other applicable provisions of the Code. Moreover, the proposed regulations define the term « transfer » to include, but not be limited to, contributions, distributions, sales and exchanges, and gifts. However, the term excludes a section 721(a) contribution to a partnership because under section 704 principles, all « Unrealized API Gains » at the time of contribution are required to be allocated to the API Holder contributing the interest when those gains are recognized by the partnership.
The broad definition of the term « transfer » can be a trap for the unwary for GPs that engage in customary estate planning. It is common for investment professionals to fund trusts with interests in carry vehicles in connection with an overall estate plan. Investment professionals must now consider the effect, if any, that section 1061 may have on such planning, as what would otherwise be tax-free transfers may now result in immediate taxation.
Property Distributions to an API Holder
The proposed regulations generally follow existing rules relating to the distribution of property with respect to an API from a partnership. Namely, that a partnership’s holding period of a distributed asset is tacked onto the holding period of a distributee partner, which then generally dictates whether a subsequent disposition of such asset is taxed under section 1061.
However, the proposed regulations provide that property (such as stock of a portfolio company) which is distributed in respect of an API remains within the scope of section 1061, and will continue to be subject to section 1061 notwithstanding that the property distributed is not itself an API.
In some cases, GPs may waive their right to receive allocations of carried interest issued by an investment fund if such allocations do not relate to assets held for more than three years. In exchange, a GP may receive an allocation of carried interest related to assets that meet the three-year holding period or some other allocation that is consistent with the economics of the deal.
The preamble to the proposed regulations cautions taxpayers that such carry waivers (and similar arrangements) may not be respected and may be challenged under existing provisions of the Code and Treasury Regulations, and/or the substance over form or economic substance doctrines; however, these proposed regulations do not add any additional hurdles to establish a viable carry waiver in an investment fund context.
Qualified Electing Fund (QEF) Not Treated as a Corporation
Generally, US persons that own stock in a passive foreign investment company (PFIC) are subject to an interest charge upon certain PFIC distributions and dispositions. A US person may elect to treat the PFIC as a QEF, the result of which requires the US person to include in its US taxable income its pro rata share of the QEF’s ordinary income and long-term capital gain, with the interest charge generally being eliminated.
The IRS believed that taxpayers could make QEF elections with respect to PFICs in which they hold an interest for the purpose of securing passthrough treatment without the application of section 1061. Thus, the proposed regulations clarify that a PFIC with respect to which a US person has a QEF election in effect is not treated as a corporation for purposes of section 1061(c)(4)(A). Accordingly, a partnership held by a QEF will be treated as an API if the interest otherwise meets the definition of an API.
US taxpayers that hold an interest in a PFIC with respect to which they have a QEF election in effect will now need to know whether interests held by the QEF are properly characterized as APIs. The proposed regulations provide that PFICs may provide additional information to its shareholders related to one-year property (i.e., « API One-Year Distributive Share Amounts ») and three-year property (i.e., « API Three-Year Distributive Share Amounts »). Moreover, if such information is not provided, its shareholders who are « API Holders » must include all amounts of long-term capital gain from the QEF in its API One-Year Distributive Share Amounts and no amounts in its API Three-Year Distributive Share Amounts.
Exception for Assets Not Held for Portfolio Investment on Behalf of Third-Party Investors
Section 1061(b) provides that to the extent provided by the Secretary of the Treasury, section 1061(a) does not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors. The statute defines a « third-party investor » as a person who holds an interest in the partnership that does not constitute property held in connection with an applicable ATB; and who does not provide substantial services for such partnership or for any applicable trade or business.
The IRS reserved issuing proposed regulations with respect to section 1061(b) and have requested additional comments.
In the preamble, the IRS acknowledges its general agreement with commentators who suggest that the section 1061(b) exception is intended to apply to family offices (i.e., portfolio investments made on behalf of the service providers and persons related to the service providers). Family office partnerships typically do not have « outside investors, » and the proposed regulations provide that the capital exception (as provided in section 1061(c)(4)(B)) rules should apply to such partnerships. It is unclear, and perhaps it will be addressed in the final regulations, whether such exception applies to protect all capital contributions made to such partnerships, particularly if such contributing partners are « service providers. »
Bona Fide Unrelated Purchaser Exception
The proposed regulations add an exception for certain purchases of an API by bona fide unrelated taxpayers. Specifically, an interest in a partnership that would otherwise be treated as an API but is purchased by an unrelated purchaser for fair market value is not an API with respect to the purchaser if: (i) the purchaser does not currently and has never provided services in the relevant ATB (or to the passthrough entity in which the interest is held, if different); (ii) does not contemplate providing services in the future; and (iii) is not related to a person who provides services currently or has provided services in the past. Notwithstanding this exception, the Service explained that such exception is inapplicable to an unrelated non-service provider who becomes a partner by making a contribution to a passthrough entity that holds an API and in exchange receives an interest in the passthrough entity’s API.
The proposed regulations generally are not effective until final regulations are published. However, the rules regarding S corporations apply to taxable years beginning after December 31, 2017, and the rules regarding PFICs are effective on the date the proposed regulations are published.