On July 31, 2020, the IRS and Treasury issued proposed regulations under section 1061 of the tax code.[1] 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.

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

• Applicable partnership interest. Section 1061 applies only to applicable partnership interests (APIs). Under the proposed 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. The proposed regulations reaffirm the IRS’ previous guidance that section 1061 applies to carried interests held by S corporations.
• Holding period. The proposed 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 proposed 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 third party after holding it for more than three years, then the proposed regulations do not recharacterize any of the gain on the sale,[2] unless a special “lookthrough” rule applies.
• Lookthrough rule. If at least 80% of a partnership’s assets are capital assets of a type subject to recharacterization under section 1061 (e.g., they were held for three years or less), then the proposed regulations treat a corresponding portion of an investment professional’s gain on the sale of a carried interest issued by that partnership as short-term capital gain, even if the investment professional has held the carried interest for more than three years.
• Transfers to related persons. Under the proposed regulations, if an investment professional transfers a carried interest to certain related persons, then, regardless of whether the transfer would otherwise be a taxable event, the investment professional must include in gross income (as short-term capital gain) any otherwise unrecognized net built-in capital gain from underlying assets with a holding period of three years or less. For this purpose, a related person generally is (1) a spouse, child, grandchild, or parent, (2) a person who provides investment advisory services 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.
• Aggregation of gains and losses. The proposed 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. The proposed regulations clarify that section 1061 does not apply to section 1231 gains (generally, gains from property used in a trade or business) or 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. The proposed 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 proposed 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 proposed regulations for tax years beginning before the final regulations are issued, as long as they consistently follow the proposed regulations.

Historically, carried interests have been a significant part of an investment professional’s compensation for providing services to hedge funds, private equity funds, or other investment partnerships. Carried interests are partnership interests issued in exchange for services that entitle the investment professional to some percentage (typically around 20%) of the partnership’s net profits after third-party investors in the partnership have realized a specified internal rate of return on their capital contributions.

Partnerships generally are not subject to an entity-level tax. Instead, each partner (including each carried interest partner) reports its allocable share of the partnership’s income, gains, losses, and deductions each year, whether or not distributed. Investment professionals typically are not taxed on the receipt or vesting of a carried interest. Moreover, because partnership items retain their character when allocated to partners, and gains from the sale of stock, securities, and other capital assets held for more than one year generally are treated as long-term capital gains in the absence of section 1061, investment professionals in private equity funds and other partnerships with buy-and-hold strategies historically have reported significant long-term capital gains in respect of their carried interests.

Over the years, a number of politicians have lambasted the perceived inequity of according long-term capital gains to investment professionals in exchange for their services while taxing everyone else at ordinary rates on their salaries. Section 1061, enacted as part of the 2017 Tax Cuts and Jobs Act, is the Trump administration’s effort to close the “carried interest loophole.” 

[1]     All section references herein are to the Internal Revenue Code of 1986, as amended, and to proposed and final Treasury regulations promulgated thereunder.

[2]     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.