On July 31, 2020, the Internal Revenue Service (“IRS”) and the Department of the Treasury released proposed regulations (the “Proposed Regulations”) providing taxpayers with definitional and computational guidance regarding how to interpret the carried interest rules under Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”). Section 1061, which was added to the Code by the Tax Cuts and Jobs Act, generally imposes a new three-year holding period requirement in order for gains arising with respect to a "carried interest" in an applicable partnership interest (an “API”) to qualify as long-term capital gain.
The Proposed Regulations provide that Section 1061 applies only to capital gains that would be treated as long-term capital gain pursuant to Section 1222. Thus, other forms of tax-favored income, including qualified dividend income taxed as long-term capital gains pursuant to Section 1(h)(11)(B), gain on property used in trade or business under Section 1231 and mark-to-market capital gains under Section 1256, are not included in any Section 1061 reporting or calculations.
Under the Proposed Rules, Section 1061 applies to individuals, trusts and estates that hold an “API”. An “API” is a partnership interest that is transferred in connection with the performance of services to an applicable trade or business. The Proposed Regulations define an applicable trade or business as any activity where “Specified Actions” are conducted at a level that would constitute a “trade or business” under Section 162 (the “ATB Test”). Specified Actions must include both (1) raising or returning capital and (2) investing or disposing of “Specified Assets” or developing Specified Assets. Specified Assets are defined generally as securities, commodities, real estate held for rental or investment, cash and cash equivalents, any partnership interest (to the extent it holds any of the foregoing) and an option or derivative contract with respect to any of the foregoing. The ATB Test aggregates Specified Actions of all related persons (using general partnerships rules of relatedness) and agents or delegates. In addition, the Proposed Regulations provide that once a partnership interest becomes an API, the partnership interest remains an API unless and until an exception applies, regardless of whether the relevant taxpayer or a related person continues to provide services in the relevant applicable trade or business.
Section 1061 does not apply to a partnership interest that is owned by a corporation. However, as previously announced by IRS in March 2018, the Proposed Regulations provide that taxpayers cannot avoid the application of these rules by holding carried interest through an S corporation. The Proposed Regulations extend this approach to passive foreign investment companies (“PFICs”) that have a qualified electing fund election in effect.
The Proposed Regulations impose additional reporting requirements on taxpayers who directly or indirectly hold APIs, as well as partnerships that issue APIs. Failure to adhere to these reporting requirements may result in penalties and an IRS determination that all gain recognized by the taxpayer with respect to a partnership is subject to recharacterization.
The Proposed Regulations generally are not effective until final regulations are published, however, the rules regarding S-corporations apply to taxable years beginning after December 31, 2017, and the rules regarding PFICs are effective on the date the Proposed Regulations are published.