The 2017 Tax Cuts and Jobs Act imposed restrictions on the treatment of capital gains for carried interests in pass-through entities, such as partnerships and S-corporations, with the enactment of Internal Revenue Code Section 1061. On July 31, 2020, the Treasury Department released proposed regulations addressing some of the questions raised by Section 1061. Broadly defined, a carried interest is an interest in a partnership given to a person or entity for the performance of services. In the world of alternative investment funds, carried interest resulting from performance allocations is a critical form of compensation for fund managers.

While a management fee is normally charged regardless of the performance of the fund, the performance allocation is meant to incentivize fund managers to maximize fund profits as it is tied directly to the success of the fund. Performance allocations entitle the fund manager to receive a fixed percentage of the profits once certain performance metrics are met. This is often up to twenty percent.

Section 1061 increases the holding period to qualify for long term capital gain treatment related to certain partnership interests, which applies to a carried interest held by fund managers. In order to qualify for long term treatment, one normally must hold a capital asset a year and one day, but under Section 1061, if you are allocated capital gains as part of a carried interest, the asset must have been held for three years for the gain to qualify for long term capital gain treatment. Thus, fund managers who hold securities for more than one year, but less than three years must reclassify what otherwise would be considered long term sales to short term for purposes of reporting their compensation.

Under the recently proposed regulations, a carried interest subject to Section 1061 is called an “applicable partnership interest” (API). APIs are held by a taxpayer as a result of performing substantial services in any applicable trade or business. This includes fund managers and other taxpayers who receive an interest in a partnership for the services they provide versus receiving an allocation of profits for invested capital. Unfortunately for fund managers, the regulations presuppose that any service which results in a taxpayer receiving a carried interest must be inherently substantial, and they provide no method of rebutting such presumption, essentially deeming all carried interests for funds are APIs.

APIs can be held by individuals or other entities, such as partnerships. The regulations adopt a partial entity approach, whereby the “pass-through taxpayer” is respected for purposes of determining whether they have an API, but the gain itself is not reclassified.  Instead, it is passed through to the “owner taxpayer” level. The pass-through taxpayer is treated as a taxpayer for the purpose of determining the existence of the API, and the owner taxpayer is the taxpayer that ultimately makes the reclassification. Once an API is determined to exist, it remains an API until an exception applies.  Transfers of the interest do not remove the API label, which means that this status should be considered in estate planning if an API is transferred to related parties, trusts, or other such vehicles.

An applicable trade or business is defined as an activity conducted on a regular, continuous, and substantial basis which consists of either the raising or returning of capital and /or the investing in and disposing of, or developing of specified assets. “Specified assets” are defined as securities, actively traded commodities, real estate investments, an interest in a partnership, option or derivative contracts, and cash or cash equivalents. For the purpose of determining the active trade or business test, simply managing the operating capital of an entity is not considered.

The regulations lay out four areas which do not qualify as an API. They include three statutory exceptions and one created as a result of the regulations:

  1. Any interest held by a corporation. The regulations clarifying this exemption only refer to C-corporations and exclude S-corporations and Passive Foreign Investment Corporations (PFIC) where the taxpayer has made a QEF election.
  2. Any interest that meets an exception for employees of entities that are not engaged in an applicable trade or business, as defined by the statute. In practice, this would apply to a person receiving profits interest for providing services to a portfolio company engaged in an operating trade or business.
  3. Any interest that was issued commensurate with a capital investment.
  4. Any interest that was classified as an API, but that has subsequently been sold to an unrelated third party that does not provide services.

Additionally, the proposed regulations clarify that only long-term capital gains under Internal Revenue Code Section 1222 are subject to reclassification. As a result, long term gains under Section 1231 or the treatment of qualified dividends do not fall under Section 1061.

The ironic nature of these regulations is that they essentially penalize fund managers for doing a good job in managing the investors’ assets, since the fund manager generally only receives a performance allocation when the fund does well. Fund managers should be aware of the implication of Section 1061, particularly in transactions where large scale capital gains are going to be realized and subject to reclassification. For hedge fund managers, there may be opportunity to target the sale of securities held for less than three years into tax years where an incentive allocation is not expected to be paid or will be much smaller, or where offsetting capital losses are also going to be realized. For private equity fund managers, Elliott Davis can be of assistance to structure the buying and selling of portfolio companies to mitigate the effects of Section 1061.

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The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change as a result of rapidly evolving legislative developments and government guidance.