If You Received Carried Interests, Profits Interest or a Promote – You Are Subject to a 3-Year Holding Rule
March 22, 2022
At a glance
- The main takeaway: The new regulations under Section 1061 impose a three-year hold on carried interests (also referred to as profits interest and promote), from one year, to qualify for long-term gains treatment for tax years beginning after December 31, 2017.
- Impact on your business: The modifications to Section 1061 will greatly impact taxpayers who have yet to allocate unfulfilled gains and are now in a three-year hold to qualify.
- Next steps: The final regulations for Section 1061 bring significant complexity for taxpayers. Aprio’s Tax Team can navigate you through the details and how they apply to you and your business.
Schedule a consultation with Aprio’s Tax Team today.
The full story:
In January of 2021, the Internal Revenue Service (IRS) issued final guidance on the taxation of carried interests under the Internal Revenue Code (IRC) Section 1061 and was enacted in the 2017 Tax Cuts and Jobs Act (TCJA). The regulation imposes a three-year hold on carried interests including, private equity and alternative asset funds, to qualify for long-term gains tax treatment for taxable years beginning after December 31, 2017.
Section 1061 limits the ability for carried interests to be eligible for long-term capital gains treatment with respect to income derived from such interests. Specifically, Section 1061 recharacterized the long-term capital gains treatment of a partner, who can be deemed as applicable partnership interests (API), from more than one year to more than three years.
The use of carried interests, profits interest and promotion are common in a variety of business situations from real estate to private equity to technology companies. It is generally utilized to provide for the future recognition of capital gain on the disposition of an asset or a business. These new rules will impact situations where the holding period is less than three years. Depending on how a sale income allocation is awarded to the taxpayers with these rewards, will make all M&A transactions much more complex for all parties involved.
The IRS has provided detailed FAQs on the reporting guidance for Section 1061 to offer clarity on the filing rules and regulations for pass-through entities and owner taxpayers. Below are the key takeaways from the reporting requirements and how they relate to pass-through entities and owner taxpayers.
- Pass-through entity reporting requirements for API holders
Pass-through entities (i.e., partnerships, S corporations and passive foreign investment companies) are required to complete Section 1061 Worksheet A the “API One Year Distributive Share Amount and API Three Year Distributive Share Amount” worksheet, provide one for each API holder and attach to the Schedule K-1 for tax returns filed after December 31, 2021. A pass-through entity is not required to apply the final regulations to returns if they filed tax years beginning before January 19, 2021, after December 31, 2021. However, they must disclose whether the information was derived under the proposed regulations or another method.
- Owner taxpayer calculations for short-term capital gains
An owner taxpayer (i.e., individuals, trusts or estates) are required to use the information provided by a pass-through entity that holds an API to determine the amount of short-term capital gains that is recharacterized under Section 1061. An owner taxpayer must complete Worksheet B and Tables 1 and 2 of the “Owner Taxpayer Reporting of Recharacterization Amount” worksheet and attach it to their tax returns filed after December 31, 2021. Similar to a pass-through entity, an owner taxpayer is not required to apply the final regulations to returns if they filed tax years beginning before January 19, 2021, after December 31, 2021. These attachments are prepared to disclose whether the information was derived under the proposed regulation or by another method.
The bottom line
With the new guidance for Section 1061, the IRS is hoping to obtain full disclosure on how taxpayers are receiving long-term capital gains for carried interests. Due to the complexity to comply and accurately file tax returns under Section 1061 on time, it’s important to pay close attention to the details. If you’re a pass-through entity or owner taxpayer, connect with your tax advisor as early as possible to avoid filing delays. Aprio’s Tax Team can navigate you through the details and how they apply to you and your business.
About the Author
Sandi is a partner in the Tax practice at Aprio, LLP. She has more than 10 years of experience providing tax services in a variety of industries, with a primary focus on the real estate industry. Sandi regularly helps real estate developers, property managers, homebuilders, real estate funds and real estate investment trusts address complex tax issues and minimize their tax liabilities.