On Friday, July 31, 2020, the IRS released a Notice of Proposed Rulemaking (Proposed Regulations) setting forth guidance under Code Sec. 1061, the so-called “carried interest” rules. The carried interest rules under Code Sec. 1061 were enacted as part of the Tax Cuts and Jobs Act (TCJA). The purpose of the rules was to recharacterize certain long-term capital gains accrued by partners receiving profits interest classified as “applicable partnership interests” (an API) and treat those gains as short-term capital gains where the API was held less than three years. These rules not only provide guidance as to what constitutes an API and which gains and losses of the taxpayer are API Gains and Losses (and, more importantly, which gains and losses are excluded from API Gains and Losses), they provide a framework for tracking ownership of an API through multiple tiers of passthrough entity ownership
The publication of these rules has been awaited for a long time. They are important for businesses across multiple industries because of the frequent use of profits interests as a form of incentive compensation. These rules are especially significant in the real estate and oil and gas industries where the use of profits interests has been common for decades. Unfortunately, the carried interest Proposed Regulations are lengthy and complex. For those of you who remember telephone directories, the printed versions of these rules resemble telephone directories of old. Their length and complexity require careful attention to detail in order to fully understand and appreciate their impact.
In this Alert, we want to focus on six important rules under the Proposed Regulations that are likely to have relatively broad application. These rules are only proposed and will be subject to a period of public comment and review. It is unclear whether all, or any portion, of the rules described below will be in the final version of the rules. Nevertheless, the rules described below describe important concepts that underpin the rules and are useful to understand their focus and breadth. The six key rules described in more detail below are:
An API does not include a capital interest in a partnership issued to a service partner in exchange for a capital contribution commensurate with the capital interest. This rule, intended to permit service partners investing capital to be taxed on the same basis as third-party, unrelated investors, is subject to a number of conditions in the Proposed Regulations that may render the exception unavailable. As a result, a service partner investing capital alongside third-party investors can be at the risk of having 100 percent of the income and gains from his capital investment made subject to the carried interest rules.
The Proposed Regulations carve out income and gains from certain assets from the operation of the rules, e.g., gains from Code Sec. 1231 property, qualified dividend income, and include some items that might not have been thought to be covered. Care must be taken in drafting agreements with a view to benefiting from the exclusions.
The Proposed Regulations restate the position of the IRS that S corporation partners owning APIs are subject to the carried interest rules, notwithstanding that the Code excludes corporations from being subject to the carried interest rules.
The Proposed Regulations provide that once a partnership interest is an API, it remains an API and never loses that character, unless one of the exceptions to the definition of an API applies. Although a transfer to an unrelated, third-party buyer will cleanse the API taint, transfers of an API held for less than three years to certain related parties, even gifts of the interest, can lead to the transferor recognizing the unrealized gain based on a hypothetical sale of the assets.
The Proposed Regulations contain very detailed rules for tiered partnerships in an attempt to trace the gain from an API in a lower-tier entity to taxpayers in upper-tier entities. These rules generally provide that the holding period of the asset is determined at the partnership level, but contain lookthrough rules and rules that taint the character of distributed property and that are certain to introduce additional complexity.
Finally, the Proposed Regulations impose complex information reporting rules on partnerships, including lower-tier entities, which will have to be addressed in the partnership agreements in supplying information to partners so that they can take advantage of exceptions to, and exclusions from, the Code Sec. 1061 rules, especially the exception for gains derived from capital interests.
This Alert is intended as a high-level summary of certain important points about these rules. More focused Alerts regarding the details of these rules will be forthcoming.
An API is a partnership profits interest held by, or transferred to, a taxpayer, in connection with the performance of substantial services by the taxpayer, or by any other related person, in any applicable trade or business. An applicable trade or business (an ATB) is generally defined in the Proposed Regulations as a trade or business that consists in whole or in part of (i) raising or returning capital and (ii) investing or developing so-called “specified assets” (generally including securities, commodities, real estate held for rental or investment, and certain derivatives). The amendments in Code Sec. 1061 were designed to permit favorable long-term capital gains treatment for gains allocable to service partners, or on account of the disposition of their interests in an API, only in cases where the interest in the asset was held for more than a three-year holding period, rather than the one-year holding period generally applicable for long-term capital gains. The amount of taxable gain subject to this extended holding period is referred to in the Proposed Regulations as the Recharacterization Amount and is the amount that the taxpayer must treat as short-term capital gain rather than long-term capital gain. Short-term capital gains are generally taxable at ordinary income tax rates.
These Proposed Regulations dramatically alter the flow of Subchapter K by requiring very detailed information reporting and partner-specific computations. The key inquiry for tax advisers may be how to structure partnership arrangements to avoid being trapped in this Sargasso Sea of complexity. That, in turn, requires becoming adept with the exclusions and exceptions to the API and ATB rules.
Exclusion for Income Attributable to a “Capital Interest” in the Partnership
The first important exclusion is that an API does not include an interest in the capital of a the partnership that provides a right to share in partnership capital commensurate with (i) the amount of capital contributed (determined at the time of receipt of such partnership interest), or (ii) the value of such interest subject to tax under section 83 upon the receipt or vesting of such interest. The purpose for such an exception is clear. Service partners receiving a carried or promoted interest are permitted to co-invest with their investor partners and obtain the same tax treatment as the investor partners on their invested capital. Although the purpose appears to be clear on its face, the implementation in the Proposed Regulations is torturous, at best, and the availability of the capital interest exclusion is subject to a number of limitations that could affect the economic deal among the parties. Moreover, the favorable treatment for a capital interest is subject to a number of potentially troublesome hurdles imposed by the Proposed Regulations.
The allocations of profits and losses under the partnership agreement must be made in the same manner to both service and non-service partners. To that end, the allocations must be based on the relative capital accounts of the partners (or owners in the case of a passthrough entity that is not a partnership) receiving the allocation 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 must be the same. An allocation to a holder of an API will not fail to qualify solely because the allocation is subordinated to allocations made to unrelated, non-service partners. Because the focus here is on allocations of income and gain, care will need to be taken in cases where partnership agreements adopt a targeted capital account model because it may not be obvious on the face of the agreement that the “same manner” requirement is met. Further, there are detailed capital account accounting rules specific to the carried interest rules that must be met and current agreements would likely need to be modified to accommodate the new rules. Partnerships might want to build appropriate flexibility into their agreements now in order to make later changes to accommodate the strictures of these rules.
The allocations on account of capital interests must be identified under the agreement and segregated from allocations with respect to an API. Further, the unrelated non-service partners must have “a significant aggregate capital account balance.” Under the Proposed Regulations, an aggregate capital account balance equal to 5 percent or more of the aggregate capital account balances of the partnership at the time the allocations are made is treated as significant.
On its face, allocations that are made on a property-by-property basis, rather than based on the taxable income and loss of the partnership as a whole, do not appear to meet the requirements of the Proposed Regulations. In that case, a taxpayer with an API would be unable to take advantage of the exclusion for items with respect to a capital investment in the partnership. A foot-fault in the drafting of the agreement or the proper allocation of items under the agreement could subject the service partner holder of a capital interest to the application of the carried interest rules across all of the interest owned.
In the case of the disposition of an interest in a partnership where the taxpayer holds both an API and a capital interest, complicated rules apply to determine and allocate any resulting gain between the API and the capital interest.
The Exclusion of Certain Partnership Assets from the Ambit of the Carried Interest Rules
The next important exception is for certain assets that are not subject to these rules at all so that the tax items from these assets are not taken into account in calculating the taxpayer’s so-called recharacterization amount, i.e., the amount a taxpayer must treat as short-term capital gain and not as long-term capital gain.
First, the new carried interest rule applies only to assets that produce capital gains or losses that are treated as long-term capital gain as a result of the Code Sec. 1222(3)-(4) holding period rules. That is, whether the gain from the sale of the asset is long-term or short-term depends on whether the asset has been held by the taxpayer for more than one year. Because Code Sec. 1231 gains and losses are treated as long-term based on the operation of Code Sec. 1231, and not Code Secs. 1222(3)-(4), and Code Sec. 1256 provides for specific character treatment, also not by reference to Code Sec. 1222, the Proposed Regulations provide that long-term capital gains determined under section 1231 or section 1256 are excluded from the operation of Code Sec. 1061. For real estate carried interests, in particular, that is an important exception. As a practical matter, a carried interest in a real estate fund based on a share of the gain on a sale of the underlying fund assets will not produce taxable gain that is required to be included in a taxpayer’s recharacterization amount.
Second, amounts treated as “qualified dividends” and any capital gain that is characterized as long term or short term without regard to the Code Sec. 1222 holding period rules, such as capital gains characterized under the identified mixed straddle rules, are also excluded.
Partnership Interests Owned by S Corporations Can Be Classified As An API
Although partnership interests held by corporations are not subject to the carried interest rules, it should come as no surprise that, under the Proposed Regulations, partnership interests held by S corporations are treated as APIs if the interest otherwise meets the API definition. The IRS announced that position in guidance issued in 2018 in response to a flurry of activity by taxpayers who realized that passthrough treatment was available through S corporations and, on its face, was outside of the ambit of the new rules. Further, a partnership interest held by a PFIC with respect to which a taxpayer has a QEF election in effect is treated as an API if the interest meets the API definition. The regulations also contain a number of other rules that may overwhelm taxpayers and their advisers accustomed to dealing with partnership profits interests under the Rev. Proc. 93-27 and 2001-43 regimes.
Once an API, Always an API, Unless an Exception Applies
The Proposed Regulations provide that once a partnership interest is an API, it remains an API and never loses that character, unless one of the exceptions to the definition of an API applies.
For example, a contribution of an API to another passthrough entity remains under the control of Code Sec. 721(a), i.e., no gain recognized, but the principles of Code Sec. 704(c) and Treas. Reg. §§ 1.704-1(b)(2)(iv)(f) and 1.704-3(a)(9) require that all unrealized API gains at the time of contribution must be allocated to the contributor. The Proposed Regulations do not appear to account for the effect of the methodology selected by the transferee for reconciling the book/tax difference and whether that methodology could be used to minimize the amount of API gain to the contributor.
A purchase of an API by a bona fide, unrelated purchaser will cleanse that API in the hands of the purchaser. On the other hand, the transfer (directly or indirectly) of an API to (i) a family member (taking into account certain attribution rules), (ii) a person who performed services for the ATB within the current calendar year or the preceding three calendar years, or (iii) to a pass-through entity to the extent a person described in (i) or (ii) above owns an interest, requires the transferor to recognize taxable gain require gain on the a transfer even if the transaction is not otherwise taxable. The calculations are based on the amount of the long-term gain that would be derived from assets of the entity held for three years or less and assuming a hypothetical liquidation of the partnership at fair market value. The term transfer includes a gift so that these rules could disrupt donative transfers undertaken as part of the service partner’s estate planning.
There is also an anti-avoidance rule so that a partner as to which an asset in a partnership would be an API cannot waive allocations from that asset in favor of increased allocations from assets that are not APIs.
The Downside of Using Tiered Partnerships
It is fair to say that the drafters of the Proposed Regulations were very concerned about the ability of taxpayers to subvert the purposes of the carried interest rules through tiered partnership ownership structures. The consequence of that fear is a myriad of very complex rules to deal with tiered partnerships. Not all of the rules are intuitive and, for tiered partnerships and their tax return preparers, applying these rules will be time consuming. As has been the case recently in the drafting of regulations, the emphasis in the Proposed Regulations is the development of very granular rules intended to confine the ability of taxpayers to manipulate the rules rather than the statement of broader principles that would allow the IRS a more flexible, principle-based, approach to enforcement. Frankly, applying very complex rules to a lot of common business transactions, where the rules may be virtually incomprehensible to the average practitioner, may do more to breed disregard of the rules than the drafters considered. Rules must not only be fair. They must be perceived of by taxpayers and practitioners as being fair. Where the rules are granular, obtuse, and packed with defined terms, and apply to many common transactions, taxpayers, and their advisers frustrated by their complexity may simply ignore the rules or adopt shortcuts that are not consistent with the detailed rules.
For example, the Proposed Regulations generally provide that if a partnership disposes of an asset, it is the partnership’s holding period in the asset that controls.
The Proposed Regulations also apply a limited “lookthrough rule” to the sale of an API with a holding period of more than three years for a capital gain that may apply to certain directly held APIs and to tiered partnership structures. Under the tiered partnership lookthrough rule, if: (i) the taxpayer holds its API through one or more passthrough entities, (ii) the taxpayer disposes of a passthrough interest held for more than three years for a gain, and (iii) either (A) the passthrough entity through which the API is directly or indirectly held has a holding period in the API that is three years or less, or (B) the passthrough entity has a holding period in the API of more than three years and the assets of the partnership in which the API is held meet a “substantially all” test, the taxpayer may be required to disaggregate the gains and losses of the lower-tier entity in order to capture the gain that should be classified as API gain. The information reporting rules require that the partnerships provide information up the ownership chain to permit the service partner to make these calculations.
The distribution of property with respect to an API generally does not accelerate the recognition of gain under Code Sec. 1061 or the Proposed Regulations. If the distributed API property is disposed of by the distributee-partner when the holding period is three years or less (inclusive of the partnership’s holding period), gain or loss with respect to the disposition is API gain or loss. Distributed API property retains its character as it is passed from partnership one tier to the next. However, at the time that distributed API property is held for more than three years, it loses its character and is no longer distributed API property. Obviously, this tracking of assets and character through multiple tiers will complicate accounting and recordkeeping and put a lot of stress on the determination that the partnership interest is not an API or that the gains are subject to one of the exceptions above.
New Information Reporting Rules
The Proposed Regulations are backed-up by new information reporting requirements. Under the Proposed Regulations, a passthrough entity in which a taxpayer holds its interest is required to provide the information needed by the taxpayer to comply with section 1061 and to determine its recharacterization amount. A failure of the partnership to provide information to the taxpayer regarding, for example, its API one year distributive share amount and its API three year distributive share amount, both items needed to complete the taxpayer’s separate calculations of its recharacterization amount, would generally result in the taxpayer being required to report certain taxpayer-favorable elements in the calculation at a $0 value. As a practical matter, profits interest partners should be certain that they have rights under the relevant partnership agreements, which may extend to lower-tier structures, to get all of the information needed for their separate computations in a timely manner. In addition, penalties can apply to the partnership if it fails to comply with the information reporting requirements. Tiered partnership entities continue to present challenges under these rules and there is a real risk that the information reporting requirements are not sufficiently rigorous that the taxpayer will have the necessary information in time to file a timely income tax return.
The Proposed Regulations are to be effective for taxable years beginning on or after the publication of final regulations. With certain exceptions, taxpayers may rely on the Proposed Regulations for taxable years beginning before the date the final regulations are published provided they follow the proposed regulations in their entirety and in a consistent manner. Certain of the rules may be relied upon by taxpayers beginning in 2020 and subsequent taxable years beginning before the date final regulations are published. Finally, and unsurprisingly, the provision of the Proposed Regulations providing that the term “corporation” does not include an S corporation for the purposes of Code Sec. 1061, is proposed to apply to taxable years beginning after December 31, 2017.
As noted, this is a preliminary, high-level summary of several important features of the carried interest rules. Additional commentary, particularly regarding the application of the lookthrough rule and the rules regarding contributions, distributions, and transfers of APIs to related persons, will be forthcoming.