Recently, the IRS and Treasury Department issued final regulations on the taxation of “carried interests” — the profit shares commonly granted to fund managers in exchange for their services. These regulations provide guidance on applying Internal Revenue Code Section 1061, which was added in 2017 by the Tax Cuts and Jobs Act. Section 1061 increases the holding period, from one to three years, for fund managers to qualify for preferential tax rates on long-term capital gains received in connection with a carried interest.
Proposed regulations released in July 2020 were criticized by some as rigid, unworkable, and failing to reflect common business arrangements among investment funds. The final carried interest regulations generally do a better job of balancing congressional intent with the fund industry’s commercial realities.
Capital Gain vs. Compensation
Alternative investment fund managers typically receive carried interests (for example, 20% of net profits) in addition to management fees. Carried interests are treated as profit shares rather than compensation for tax purposes. Because funds’ profits often consist of material long-term capital gains, a significant portion of a manager’s carried interest is generally taxable at a rate of 20%. Critics have long argued that carried interests are compensation and that it’s unfair to tax a manager’s compensation at lower rates when other workers’ compensation is taxable at rates as high as 37%.
To address this perceived unfairness, Section 1061 recharacterizes certain net long-term capital gains (on assets held between one and three years) as short-term gains taxable at ordinary income rates. It limits preferential long-term capital gain treatment to assets held more than three years rather than the usual one-year period. Section 1061 covers “applicable partnership interests” (APIs) — partnership interests transferred to, or held by, noncorporate taxpayers in connection with the performance of substantial services in an “applicable trade or business.” Generally speaking, APIs are carried interests in certain investment funds.
One argument against the traditional tax treatment of carried interests is that managers aren’t risking their own capital. Therefore, they shouldn’t benefit from preferential capital gains tax rates. To accommodate situations in which managers also invest their own capital, an interest isn’t an API if it “provides the taxpayer with a right to share in partnership capital commensurate with the amount of capital contributed or the value of such interest subject to tax under Section 83” when the interest is received or vested.
Final Carried Interest Regulations Highlights
The final carried interest regulations modify the proposed regulations in several important ways. Here are some highlights.
Capital interest exception. The proposed regulations would apply the capital interest exception to allocations made to API holders “in the same manner” as allocations to “unrelated non-service partners” who have made significant capital contributions (more than 5% of the partnership’s aggregate capital account balance). Allocations would satisfy the “same manner” requirement if they:
- Were based on the partners’ relative capital accounts, and
- The terms, priority, type, and level of risk, rate of return, and rights to cash or property distributions during the partnership’s operations and on liquidation, were the same.
Commenters argued that this approach ignores commercial realities. For example, many funds use targeted allocations or don’t maintain capital accounts — making it impossible to qualify for the capital interest exception. Also, it’s common for fund managers to receive tax distributions and have different withdrawal rights, liquidity rights and expense allocations than other investors.
The final regulations replace “same manner” with “similar manner.” Under this standard, fund managers satisfy capital interest exception requirements if their allocations and distribution rights are “reasonably consistent” with those of unrelated non-service partners who have made significant aggregate capital contributions. The final carried interest regulations outline factors to consider in applying this test and confirm that certain common commercial arrangements won’t disqualify fund managers from the exception.
Debt-financed capital interests. Under the proposed regulations, an interest wouldn’t qualify for the capital interest exception if it was acquired with a loan or other advance made or guaranteed by a partner, the partnership, or certain related persons. Recognizing that management companies commonly make loans to help employees fund their capital contributions, the final regulations contain an exception. Debt-financed capital interests qualify for the exception if the borrower is personally liable for the debt, meaning that:
- The loan is fully recourse to the borrower,
- The borrower has no right to reimbursement, and
- The debt isn’t guaranteed.
Lookthrough rule. Regulators were concerned that taxpayers could skirt Section 1061 by selling an API held for more than three years, even though the underlying partnership assets had substantially shorter holding periods. To discourage this, the proposed regulations would treat capital gain on the sale of an API as short-term if 80% or more of the partnership’s assets would generate short-term gain under Section 1061 if disposed of by the partnership. This lookthrough rule would be burdensome to apply, especially for tiered partnership structures. The final regulations limit the application of the lookthrough rule to situations where, if at the time an API held more than three years is disposed of, either:
- The API would have a holding period of three years or less if the period before third-party investors had capital commitments to the partnership is excluded, or
- A transaction or transaction series “has taken place with a principal purpose of avoiding potential gain recharacterization under section 1061(a).”
Related party transfers. Section 1061(d) recharacterizes certain long-term capital gain as short-term capital gain when a taxpayer transfers an API held for three years or less to a related person. The proposed regulations interpreted this provision to accelerate gain, even if the transfer otherwise qualified for nonrecognition treatment. The final carried interest regulations clarify that Section 1061(d) applies only to transfers in which gain is otherwise recognized. Note, however, that unrecognized gains remain subject to recharacterization under Section 1061 when ultimately recognized.
The final regulations generally apply to tax years beginning on or after January 19, 2021. Contact your Untracht Early advisor for more information.