The IRS has issued proposed regulations (REG-107213-18) under IRC Section 1061, which recharacterizes as short-term capital gains certain net long-term capital gains of a partner holding one or more applicable partnership interests (APIs). An API is 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 any related person in an applicable trade or business.

The proposed regulations provide some clarifications on how to apply IRC Section 1061. In part, the proposed regulations:

• Clarify that IRC Section 1061 does not apply to recharacterize a taxpayer's IRC Section 1231 gains or qualified dividends included in net capital gain for purposes of IRC Section 1(h)(11)(B)
• Explain how capital gain dividends of a real estate investment trust (REIT) would be treated for purposes of IRC Section 1061, excluding such amounts from IRC Section 1061 to the extent attributable to capital assets held for more than three years
• Provide detailed mechanics for (i) determining the extent to which a partner's allocations are subject to the IRC Section 1061 rules and (ii) excepting from the rules items that are properly allocable to a capital interest
• Would apply IRC Section 1061 to APIs held by S corporations, and APIs held by a passive foreign investment company with respect to which the shareholder has a qualified election fund election
• Would subject dispositions of property distributed to an API holder to IRC Section 1061 recharacterization
• Would apply IRC Section 1061 recharacterization to certain sales of partnership interests, even when the holding period in the interest exceeds three years
• Would amend the holding period rules to address holding periods for split profits interests
• Would require securities partnerships to separately account for APIs under IRC Section 704(c)

The Preamble to the proposed regulations cautions taxpayers against carry waivers or carried-interest waivers, as these and similar arrangements may not be respected and may be challenged under IRC Section 707(a)(2)(A), Treas. Reg. Sections 1.701-2 and 1.704-1(b)(2)(iii), and/or the substance-over-form or economic-substance doctrines.

A 60-day period is being provided for public comments and requests for a hearing. Taxpayers and partnerships may rely on the proposed regulations for tax years beginning before the final regulations are published in the Federal Register, as long as they consistently follow the proposed regulations in their entirety. The proposed regulations would apply for tax years beginning after December 31, 2017, for the exception under IRC Section 1061(c)(1) to the definition of an API not applying to a partnership interest held by an S corporation.

The proposed regulations would affect investment funds, including private equity and alternative asset funds (i.e., hedge, real estate, energy, infrastructure, and fund of funds), and the managers and general partners of these funds.

A Tax Alert is forthcoming.