On January 7, 2021, the IRS and Treasury issued final regulations under section 1061 of the tax code. Section 1061 imposes a three-year holding period as a precondition to recognizing long-term capital gains on carried interests issued to investment professionals, and otherwise treats the capital gains as short-term capital gains. Individuals are taxed at preferential rates on long-term capital gains, but not on short-term capital gains.

The final regulations largely adopt proposed regulations that were issued in July 2020 (which we discussed here) while making some taxpayer-favorable changes, including:

• Expansion of capital interest exception. The final regulations reduce the situations under which section 1061 would recharacterize gains from invested capital as short-term capital gains.
• Limitation of lookthrough rule. The final regulations limit the applicability of the “lookthrough rule” contained in the proposed regulations.
• No gain acceleration on related-person transfers. The final regulations do not require taxpayers to recognize gain on a transfer of a carried interest to a related person if the transfer is otherwise tax-free.

Here are some of the most significant aspects of the final regulations:

• Applicable partnership interest. Section 1061 applies only to applicable partnership interests (APIs). Under the final regulations, virtually all carried interests issued to investment professionals (either directly or through an aggregating entity, such as a fund’s general partner) are APIs. However, APIs do not include (1) interests in C corporations, other than a passive foreign investment company with respect to which a qualified electing fund election is in effect, (2) certain capital interests, or (3) certain partnership interests held by employees of entities not engaged in an investment advisory business. Like the proposed regulations, the final regulations apply section 1061 to carried interests held by S corporations.
• Capital interests. An interest that has a positive liquidation value at grant (e.g., an interest received in exchange for a capital contribution) generally is not an API if allocations in respect of the interest are made in a “similar manner” to allocations with respect to capital interests held by similarly situated non-investment professionals who (1) are unrelated to the investment professional holding the capital interest and (2) have contributed at least 5% of the partnership’s aggregate capital.
  
  The final regulations provide that allocations to an investment professional can be “similar to” allocations to non-investment professionals even if the investment professional’s allocations are subordinated to other allocations or are unreduced by managed fees or carry, the investment professional is entitled to tax advances, or the partnership permits investors to opt out of certain investments. By contrast, the proposed regulations had required all putative capital interest allocations to be “made in the same manner to all partners,” and thus would have treated an investment professional’s capital interest as an API in these situations.
  
  A partnership interest received in exchange for a contribution of funds loaned or guaranteed by the partnership, another partner, or a related person (such as the management company) is not a capital interest unless the investment professional is personally liable for the loan. Loaned funds that are excluded from the definition of capital interest are treated as capital contributions (and thus give rise to a capital interest) only as they are paid down from the investment professional’s own funds.
• Holding period. Like the proposed regulations, the final regulations determine the three-year holding period in section 1061 by reference to the owner of the asset sold, whether the asset is the carried interest itself or an asset held by the partnership that issued the carried interest. Thus, the regulations recharacterize gain from the sale of an asset that a partnership has held for three years or less as short-term capital gain to the extent that the gain is allocated to an investment professional on its carried interest, even if the investment professional has held the carried interest for more than three years. By contrast, if the investment professional sells the carried interest to an unrelated person after holding it for more than three years, then the proposed regulations do not recharacterize any of the gain on the sale, unless a special “lookthrough” rule applies. (Under section 751, the gain still is taxed as ordinary income to the extent it is attributable to accrued market discount or other “hot assets” held by the partnership.)
• Lookthrough rule. A special “lookthrough rule” applies to the sale of an API if either (1) a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under section 1061 or (2) the API has a holding period of three years or less at the time of sale, determined by counting only the period since an unrelated non-investment professional was legally obligated to contribute an amount equal to at least 5% of the partnership’s total capital contributions (determined as of the time of sale). The preamble to the final regulations notes that clause (2) is necessary to prevent fund managers from trying to circumvent section 1061 by establishing partnerships and leaving them inactive for three years before attracting investments from limited partners.
  
  If the lookthrough rule applies, then all of the investment professional’s gain on the sale of the API that is attributable to partnership assets held for three years or less is recharacterized as short-term capital gain.
  
  The proposed regulations would have applied the lookthrough rule whenever at least 80% of a partnership’s assets were held for three years or less, regardless of the investment professional’s holding period. Commenters had expressed concern that the lookthrough rule in the proposed regulations would have been difficult to comply with, particularly in tiered arrangements where information about the underlying assets might not have been readily available.

• Transfers to related persons. The final regulations include a rule similar to the lookthrough rule if a taxpayer sells an API to certain related persons. For this purpose, a related person generally is (1) a spouse, child, grandchild, or parent, (2) a person who provides investment advisory services to the same partnership within the same calendar year as, or the three years preceding, the transfer, or (3) a pass-through entity owned by either of the foregoing.
  
  This rule is significantly narrower than the corresponding rule in the proposed regulations, which would have accelerated income to the transferring investment professional even if the transfer was otherwise tax-free (e.g., a gift or a contribution to another partnership).
• Aggregation of gains and losses. Like the proposed regulations, the final regulations aggregate gains and losses from multiple carried interests at the ultimate beneficial owner level before determining the amount subject to recharacterization.
• Disapplication to certain assets. Like the proposed regulations, the final regulations clarify that section 1061 does not apply to section 1231 gains (generally, gains from real or depreciable business property) or to qualified dividend income.
• Flow-through rule for RIC and REIT dividends. Regulated investment companies and real estate investment trusts can designate dividends they pay as capital gain dividends to the extent of their net underlying long-term capital gains. Like the proposed regulations, the final regulations allow these entities to report the amount of their capital gain dividends that are attributable to assets held for more than three years, and allow carried interest holders to use this information to reduce the amounts of their allocated capital gains that are subject to recharacterization. The regulations contain similar rules for passive foreign investment companies with respect to which a qualified electing fund election is in effect.
• Applicability date. Taxpayers and partnerships generally can rely on the final regulations for tax years beginning before they were issued, as long as they consistently follow the regulations.