Brief Overview of Section 1061

Section 1061 recharacterizes certain long-term capital gains as short-term capital gains (generally taxed at less favorable rates) when allocated to taxpayers that hold, directly or indirectly, an “applicable partnership interest” (an “API”), which is the Section 1061 term for what is often referred to as a carried interest. An API for this purpose is generally defined as a partnership interest that is transferred to or held by a taxpayer in connection with the performance of substantial services (by the taxpayer or a related party) with respect to an “applicable trade or business” (generally raising or returning capital and providing investment management services – an “ATB”). Section 1061 extends the holding period required to achieve long-term gains status for a covered disposition from one year (under current law for long-term capital assets)‎ to three years, thus requiring a longer investment period in order for the holder of an API to benefit from the long-term capital gains rates.

Primary Changes to the Proposed Regulations

While the Final Regulations largely adopt the Proposed Regulations, there were four primary areas of changes made to the Proposed Regulations including (1) the capital interest exception, (2) the treatment of capital interests acquired with loan proceeds, (3) the look-through rule for certain API dispositions, and (4) transfers of APIs to certain related persons.

Capital Interest Exception -- The Final Regulations provide for a revised rule that looks to whether allocations are commensurate with capital contributed. This rule expands the definition of capital interest allocations as contained in the Proposed Regulations. Under the Final Regulations, an allocation will be considered a capital interest allocation (and thus excepted from treatment as an API) if the allocation to the API holder with respect to its capital interest is determined and calculated in a similar manner to the allocations with respect to capital interests held by similarly situated unrelated non-service partners who have made significant aggregate capital contributions. Unrelated non-service partners will be treated as having made ‎significant aggregate capital contributions to the extent such partners possess ‎five percent or more of the aggregate capital contributed to the partnership ‎at the time the allocations are made‎. The Final Regulations do not address situations where unrelated non-service partners in the aggregate do not hold at least five percent of the aggregate capital contributed. 

The determination of whether partners are similarly situated may be made on an investment-by-investment or class-by-class basis. The Final Regulations specifically provide that an allocation to an API holder will not fail to qualify solely ‎because:‎

• The allocation is subordinated to allocations made to ‎unrelated non-service partners;‎
• An allocation to an API holder is not reduced by the cost ‎of service provided by the API holder where the cost of services provided ‎includes management fees or API allocations; or
• An API holder has a right to receive tax distributions (even though unrelated non-service partners do not) where such ‎distributions are treated as advances against future ‎distributions.‎

The Final Regulations retain the requirement that allocations with respect to contributed capital be clearly identified under both the partnership agreement and the partnership’s books and records as separate and apart from allocations made to the API holder with respect to its API, and specify that the books and records must be contemporaneous. The Final Regulations do not provide for the grandfathering of any existing partnership agreements. Allocations made to an API holder that do not meet the requirements of the Final Regulations will not be considered capital interest allocations. Taxpayers will need to determine whether any of their existing partnership agreements should be amended to comply with these standards.

Capital Interests Acquired with Loan Proceeds -- The Final Regulations contemplate that capital contributions made by a service partner with loan proceeds from another partner or a person related to such partner (other than the partnership) may qualify for the capital interest allocation exception so long as the individual service provider is personally liable for the repayment of such loan. Under the Final Regulations, the loan must be fully recourse to the individual service provider, the individual service provider cannot have any right to be reimbursed by any person, and no person may guarantee the individual service provider’s loan. Treasury and the IRS, however, continue to study the treatment of ‎guarantees generally in light ‎of questions about who the borrower is for ‎federal tax purposes.‎

Look-through Rule for Certain API Dispositions -- Both the Final Regulations and the Proposed Regulations provide for certain look-through rules that ‎can apply when the holder of an API with a holding period greater than three years disposes of the ‎API in either a direct or indirect (i.e., when the API is held through one or more passthrough ‎entities) sale resulting in all or a portion of the gain on such sale being subject to taxation at short-term rates. The Proposed Regulations contained a substantially all test to determine the applicability of the look-through rules based upon whether 80% or more of assets held directly or indirectly by a passthrough entity have a holding period of three years or less. The Final Regulations replace this substantially all test with a rule that the IRS believes more narrowly targets taxpayers that appear to be engaged in abusive practices to avoid section 1061(a) recharacterization. The look-through rules under the Final Regulations apply to situations where either:

1. the API would have a holding period of three years or less if it were determined by not including any prior period where an unrelated non-service partner is not legally obligated to contribute substantial money or property directly or indirectly to the relevant passthrough entity, or
2. a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under Section 1061(a).

For purpose of clause 1. above, a substantial legal obligation to contribute money or property is an obligation to contribute a value that is at least five percent of the partnership’s total capital contributions determined as of the time of the API disposition. The IRS’ stated concern is that without this rule, fund managers might attempt to avoid the recharacterization of gains by establishing partnerships and leaving them inactive for three years before attracting investment from limited partners. The application of this five percent rule may have some unexpected results to the extent any new obligations to contribute capital contributions have been made in the three years prior to an API disposition. Further, it is somewhat unclear whether valuation increases or decreases after the relevant contribution may or should be considered when making this determination. Taxpayers will need to carefully consider the applicability of the look-through rules upon any API disposition.

Transfers of APIs to Related Persons -- The Proposed Regulations contemplated the acceleration of taxable gain upon the transfer (including otherwise non-taxable transfers) of an API to certain “related persons.”² The Final Regulations reflect a change in position on this treatment. The IRS determined that while Section 1061(d) can be interpreted as an ‎acceleration provision, in the absence of clear language to the contrary, it is ‎more appropriate to apply Section 1061(d) only to transfers in which long ‎term capital gain is otherwise recognized.‎ To address this, the Final Regulations added the term “Section 1061(d) Recharacterization ‎Amount” which represents an Owner Taxpayer’s (defined below) share of the amount of net long-‎term capital gain from assets held for three years or less that would have ‎been allocated to the Owner Taxpayer upon a hypothetical liquidation of the partnership (or portion thereof). Under the Final Regulations, upon a sale or exchange of an API to a “related person” pursuant to which gain is recognized by the Owner Taxpayer, the lesser of ‎‎(i) the amount of net long-term capital gain recognized by the Owner ‎Taxpayer upon the transfer of such interest, or (ii) the Section 1061(d) ‎Recharacterization Amount‎ will be recharacterized as short-term capital gain. The Final Regulations also provide for some consistency in the determination of the gain to be recharacterized by incorporating certain exceptions found in other sections of the Final Regulations.³ The Final Regulations further clarify that for purposes of Section 1061(d), an Owner Taxpayer will be treated as transferring the Owner Taxpayer’s share of any indirect API or distributed API if the indirect API or distributed API is transferred by the API holder to a person that is a “related person” for purposes of Section 1061(d) with respect to the Owner Taxpayer.

Other Changes to the Proposed Regulations

The Final Regulations revised the Proposed Regulations to taxpayers’ advantage by modifying the formulas used to determine the amount of income associated with an API that its holder must treat as short-term ‎capital gain ‎under Section 1061 (the ‎‎“Recharacterization Amount”). Such modifications include allowing for capital losses to be factored into the formula. This will allow for capital losses to be utilized where an Owner Taxpayer holds multiple APIs with both loss and gain. 

The Final Regulations continue to treat distributed API property as subject to section 1061(a), however, the Final Regulations provide for the exclusion from the calculation of the API one year disposition amount of ‎items that are treated as capital gain without regard to the ‎holding period ‎requirements of Sections ‎‎1222(3) and (4) such as so-called Section ‎‎1231 gains, qualified dividend income, Section 1256 ‎‎marked-to-market capital gain, and capital ‎gains and losses characterized under the mixed ‎straddle ‎period rules of Section 1092(b). This exclusion allows for the incorporation of similar exceptions to API treatment found in other sections of the Final Regulations.

The Final Regulations do not include certain partnership transition amount rules contained in the Proposed Regulations⁴ as they were determined to be unnecessary.

The Final Regulations revise certain reporting rules. Under the reporting rules, if an Owner Taxpayer is not furnished the relevant information for a passthrough entity or is not otherwise able to substantiate the information, the Owner Taxpayer’s Recharacterization Amount may be increased due to loss of certain exceptions in the calculation of such Recharacterization Amount. Further, in the event certain information is to be provided by a passive foreign company with respect to which the shareholder has a QEF election (as described in Section 1295(a)), the Owner Taxpayer may not be permitted to separately substantiate the information. Taxpayers will want to ensure that their API investments are required to furnish the appropriate information.

Notable Areas Where Changes Were Not Made

Definition of Taxpayer -- The Final Regulations retain the definitions of “taxpayer” contained in the Proposed Regulations. Section 1061 uses but does not define the term “taxpayer,” causing some uncertainty as to ‎how its provisions should apply to partners who hold interests in passthrough entities ‎which themselves hold an API. The Proposed Regulations clarified that for such purposes the term “taxpayer” includes both a ‎person subject to tax on the net gain with respect ‎to an API (referred to as an “Owner Taxpayer”) and ‎passthrough ‎entities that hold an interest in an API‎ (referred to as a “Passthrough Taxpayer”). Owner Taxpayers generally include individuals, simple and ‎complex trusts, and estates. Passthrough Taxpayers may include (i) the entity service provider, (ii) a ‎person related to the service provider, ‎‎(iii) entities engaged in an ATB, or (iv) the recipient of an interest ‎in connection with the performance of ‎substantial services in an ATB.

Section 1231 Gains -- The Final Regulations adopt the position in the Proposed Regulations that items that are treated as capital gain without regard to the ‎holding period ‎requirements of Sections 1222(3) and (4) are excluded from Section 1061. ‎This includes so-called Section ‎‎1231 gains, qualified dividend income, Section 1256 ‎marked-to-market capital gain, and capital ‎gains and losses characterized under the mixed ‎straddle period rules of Section 1092(b).

Treatment of S Corporations -- The Final Regulations, like the Proposed Regulations, also confirm the view of ‎the IRS that Section 1061 ‎recharacterization applies to carried ‎interests held by “S corporations.”

Expansion of Partnership Interest to Include Other Financial Instruments -- The Final Regulations retain the concept set forth in the Proposed Regulations that certain ‎financial instruments that do not constitute partnership interests for general income tax purposes ‎could be treated as an API if the value of such instrument is determined in whole or in part by ‎reference to the underlying partnership. However, Treasury and the IRS continue to study the impact of section ‎‎1061 on the taxation of enterprise value related to the transfer or exchange of ‎partnership interests and management contracts.

Substantial Services Presumption -- The Final Regulations retain the Proposed Regulations’ presumption that all services ‎provided for a partnership interest are substantial services for purposes of Section ‎‎1061. However, Treasury and the IRS will continue to study and ‎consider possible circumstances under which the presumption might be rebutted as ‎well as the possibility of providing safe harbors for circumstances under which the ‎presumption will not apply.

Third-Party Purchaser Exception -- ‎The Final Regulations do not expand the third-party purchaser exception to API treatment to include non-sale transfers (such as contributions to a passthrough entity holding an API in a nonrecognition transaction). The Final Regulations do, however, in an attempt to reduce uncertainty add a clarifying exception to Section 1061 providing that the term API does not include an interest in a partnership that would be treated as an API but is held by a bona fide purchaser of the interest who does not currently and has never provided services in the relevant ATB and who is not related to a person who provides services currently or has provided services in the past. 

Areas Still Under Review

The introductory summary to the Final Regulations specified several areas that Treasury and the IRS are continuing to study including the following:

• With respect to capital interest allocations, the application of the similar manner requirement to S corporations and the application of the capital interest exception to co-invest vehicles.
• Basis proration upon a partial interest sale where a partner holds a partnership interest comprised of both an API and a capital interest.
• With respect to partner loans, the treatment of guarantees generally in light of questions about who the borrower is for federal tax purposes.
• The look-through rules and whether gains associated with goodwill or enterprise value should retain the holding period of the partnership itself (as opposed to the underlying assets) and whether the look-through rule should apply only to the gain associated with the hypothetical liquidation of the underlying assets.
• With respect to the definition of partnership interests including financial instruments, the impact of Section 1061 on the taxation of enterprise value related to the transfer or exchange of partnership interests and management contracts.
• With respect to the presumption that all services provided for a partnership interest are substantial services, possible circumstances under which the presumption might be rebutted as well as the possibility of providing safe harbors for circumstances under which the presumption will not apply.
• The determination of ATB and safe harbors (in the context of activities occurring in separate partnership tiers or entities being considered combined and treated as one ATB). However, Treasury and the IRS noted that the definition of ATB includes all activities, no matter how minimal, conducted by entities that are related persons to each other, for purposes of determining whether the ATB activity test is met, and if that test is met, then each such participating entity is considered to be engaged in an ATB.
• The treatment of partnerships that engage in the production, storage, transportation, processing, or marketing of physical commodities in the ordinary course of business (including hedges with respect to commodities).
• Concerns raised relating to the computation rules for the determination of the Recharacterization Amount including the order of steps under Section 1(h)(1), Section 1231 and Section 1256 not being excluded upon a partnership interest sale and the suspension of the holding period of an API when an API owner seeks to obtain a more than three year holding period without taking on additional risk (i.e., hedging of the API).
• Concerns raised relating to how the distributed API property rules apply where an API holder owns both a profits interest and a capital interest in a partnership, and how to apply any recommended rule in the context of a tiered structure.
• In the context of REIT and RIC disclosures, comments suggesting that the disclosure of this information be separated from the reporting of capital gain dividends.
• Apportioning QEF E&P limitation –
   
  • Treasury and the IRS determined this issue warrants further study (and invited comments) due to the complexity regarding the different scenarios under which a pro rata approach or an alternative approach would be more appropriate. Until Treasury and the IRS issue further guidance on this issue, taxpayers may adopt any reasonable method for apportioning the QEF E&P limitation for purposes of Section 1061 taking into account these considerations.
  • Treasury and the IRS further determined to continue to study whether to provide a rule that would identify an Owner Taxpayer’s distributive share of a QEF’s net capital gain from a passthrough entity attributable to the Owner Taypayer’s qualifying capital interest and API.
• A specific method for taking Section 1061 ‎into account in applying the aggregation rule for securities partnerships‎ under Treasury Regulation § 1.704-3(e).
• The Section 1061(b) Exception (including an exception for family offices)
• Whether a simplified method for determining and calculating API gain or loss for small partnerships is warranted and the criteria that should be used to determine which partnerships should be eligible to use such simplified method.

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