Proposed Regulations for Carried Interest – Is It Time to Analyze Business Strategies?

When the Tax Cuts and Jobs Act of 2017 introduced the new carried interest rules through IRC Section 1061, it upended compensation models that had been utilized by a wide variety of professionals and industries, most notably real estate developers, private equity and hedge fund managers. The new rules extended the holding period from 1 year to 3 years to receive capital gains treatment for carried interests issued in exchange for services. If they do not meet the 3-year holding period when the sale occurs, any potential capital gain qualifying income is recharacterized and taxed at ordinary tax rates.

The TCJA legislation left many unanswered questions, adding to the tension created between general partners/member managers and investors. New proposed regulations announced on July 31, 2020, however, provide crucial clarifications, some notable exceptions, and a bit of good news.

Brief Overview of Key Definitions

The proposed regulations mostly followed the original rules when defining key terms, but also provided necessary clarifications on a few key definitions:

• An Applicable Partnership Interest (API), originally defined as any partnership interest received in return for substantial services provided in an applicable trade or business, now also includes services performed by an employee and any financial instrument or contract. A carried interest, profits interest, or promote would be considered an API.
• The rules for an applicable trade or business are now simplified, stating that a Taxpayer meets those rules if its regular and consistent activities related to raising or returning capital, investing in or disposing of specified assets, and developing specified assets, rise to a level of activity that would be defined as a trade or business under IRC Section 162.

The Long-Awaited News

The proposed regulations provided some good news regarding certain income and holding periods:

• Real estate and hedge funds receive some reprieve from the rules. In a welcome clarification, carried interest holders in real estate entities will not be subject to recharacterization if the underlying income event is generated from the sale of depreciable or real property used in a trade or business. Similarly, hedge fund managers will not have to recharacterize gains from marked to market derivative contracts under Section 1256. Additionally, qualified dividends will not be subject to the recharacterization.
• Holding Period: When does the clock start on the 3-year rule? In general, the proposed regulations provide that the owner of the asset determines the holding period. If a Passthrough Entity sold an asset that it held for 3 years, then the holding period of that asset will be 3 years, even if a partner came into the entity after the asset was acquired. This is especially important when an investor has a less then 3-year holding period in their interest, as it allows them to still qualify for capital gains treatment if the assets sold were held by the reporting entity for more than 3 years. The holding period rules can also come into play when a company has a tiered Passthrough Entity structure where the lower tier entity holds an API interest. The upper-tier investors do not need to worry about how long they held their interests as long as the lower-tier entity held the API interest for more than 3 years.

Some of the most noteworthy points in the proposed regulations include the explanations of exceptions to the carried interest rules, including:

• Investments through Passthrough Entities: Code Section 1061 was silent as to whether carried interests held through certain Passthrough Entities would be subject to the new rules. The proposed regulations clarify that S Corporations and Passive Foreign Investment Companies (PFICS) with a qualified electing fund election are considered eligible entities that fall under the Section 1061 rules and regulations.
•  Certain capital interests: In many cases, an API holder receives an interest in a Passthrough entity in exchange for both contributions of cash or other property and performance of services. To the extent long-term capital gains represent a return on invested capital to the holder, they are not required to recharacterize these gains. The rules take on a more stringent approach applying a pro-rata formula, making it difficult to blend the two types of interests together. Capital contributions funded by debt from another partner, the Passthrough Entity, or a related party are not subject to the capital interest exclusion.
• Acquired API. The proposed regulations provide an exception to the carried interest rules for an API that is acquired by a bona fide purchaser, with some stipulations. First, the purchaser must not provide services. Second, the purchaser must be unrelated to any service provider. Finally, the purchaser must have acquired the interest for fair market value. This is one of the few exceptions to the API taint, as the proposed regulations point out that an API characterization does not easily go away once it is determined (i.e., distribution or transfer to estate).

Understanding the Impact

The proposed regulations attempt to close some perceived loopholes created by Section 1061. If one of the situations below sound familiar, you may be impacted by the proposed regulations on carried interest and should work with an Aprio advisor to understand the impact.

• Carried Interest Waivers – Some taxpayers have attempted to circumvent Section 1061 through “carry waivers” or “carried interest waivers,” waiving their rights to gains generated from the disposition of a partnership’s capital assets held for 3 years or less and, in turn, substituting these gains with gains generated from capital assets held for more than 3 years. The proposed regulations make clear that the IRS may not respect these and similar arrangements, and they may be challenged under examination.
• Related Party Transactions – Transfers of APIs to related parties may cause accelerated gain recognition subject to recharacterization under the proposed regulations. Such a transfer would typically occur as part of an estate or gifting plan. Taxpayers with an existing estate plan or who are currently developing an estate plan and making gifts or transfers involving APIs should consult with their tax advisor to avoid unexpected tax consequences.
• Tiered Structures and API – For partnerships in a tiered Passthrough Entity structure, the proposed regulations state that the API gains and losses will retain its character up through the tiers to the Taxpayer that reports and pays income tax on the gain. Even though this Owner Taxpayer has a capital investment in the upper-tier partnership, if that upper-tier partnership holds an API, a capital gain allocated from that API may still be recharacterized as ordinary income at the Owner Taxpayer level.
• Installment Sales – In some cases, Taxpayers attempted to avoid the 3-year holding period requirement on carried interests by structuring the gain recognition event as an installment note with deferred cash payments. The proposed regulations warn that such a structure can potentially expedite ordinary gain recognition.
• REIT and RIC Capital Gain Dividends – The proposed regulations establish that REITs and RICs can benefit from long-term capital gain treatment but are required to disclose to the Taxpayer how much is subject to recharacterization as ordinary income. If such disclosure is not done appropriately, then all such capital gain dividends could be presumed subject to the recharacterization under Section 1061.

Bottom Line

The new proposed regulations seek to provide clarity to the new carried interest rules. The IRS is also seeking public comment for the next 30 days. Based on that input as well as further analysis, they may further augment the proposed regulations. More changes are on the horizon, and Aprio will be monitoring for further updates.

If you think you may be impacted by the recently proposed regulations to the carried interest rules, consider working with an Aprio advisor now to create an appropriate tax strategy before the rules are finalized. Reach out to Jake Patton, Lena Klaskala, or Ori Epstein for further guidance.