08 February 2021 Final IRC Section 1061 carried interest regulations have implications for passthrough entities, including private equity and alternative funds, and their professionals On January 19, 2021, the IRS published final carried interest regulations under IRC Section1 1061, as well as related partnership and holding period provisions (the Final Regulations). The Final Regulations generally follow the approach taken by proposed regulations published on August 14, 2020 (the Proposed Regulations),2 with several notable exceptions. IRC Section 1061, enacted by the Tax Cuts and Jobs Act of 2017, generally requires certain carried interest arrangements to be held for more than three years for the related capital gains to qualify for tax-favored long-term capital gain (LTCG) treatment. This requirement applies to carried interests in many private equity (PE) funds, hedge funds and other alternative asset management funds. When it applies, IRC Section 1061 recharacterizes gains from the sale of capital assets held for one to three years, otherwise eligible for taxation at LTCG rates, as short-term capital gains (STCG), typically taxed at the rates applicable to ordinary income. Most significantly, the Final Regulations addressed comments on, and made important revisions to, three key aspects of the rules:
Compared to the approach taken in the Proposed Regulations, the Final Regulations adopt a more flexible approach to the capital interest exception that attempts to take into account standard market practices. Another welcome change is that the Final Regulations narrowed the scope of the related-person transfer rule under IRC Section 1061(d) by clarifying that it is a recharacterization provision rather than an acceleration provision. Less helpful for many taxpayers will be the limited exception to the rule on disqualified loans and guarantees; as currently drafted, the exception may preclude many loan-funded capital contributions of PE fund professionals from qualifying for the capital interest exception (e.g., if those contributions are funded with borrowed cash and a related management company or another fund affiliate has guaranteed the borrowings). Additionally, the Final Regulations provide disparate treatment for future earnings on (i) a carried interest holder's capital attributable to previously recognized long-term capital gains versus (ii) capital attributable to other amounts (including unrealized gains), which may adversely impact certain hedge funds. Effective date is generally prospective (2022 and beyond for calendar-year-end taxpayers), with some exceptions The Final Regulations generally apply to tax years of "Owner Taxpayers" (i.e., individual, trusts or estates) and "Passthrough Entities" (i.e., partnerships, S corporations, passive foreign investment companies (PFICs) with a "qualified electing fund" (QEF) election in effect, trusts and estates) beginning on or after January 19, 2021. This means the Final Regulations are generally effective for a calendar-year-end taxpayer beginning in 2022. However, the Final Regulations will apply to any partnership formed on or after January 19, 2021. Taxpayers may elect to apply the Final Regulations early, provided they apply the regulations in their entirety to that tax year and all subsequent tax years. Treas. Reg. Section 1.1061-3(b)(2)(i), which provides that the exception for APIs held by corporations does not apply to APIs held by S corporations, applies to tax years beginning after December 31, 2017. Treas. Reg. Section 1.1061-3(b)(2)(ii), which provides that the exception for APIs held by corporations does not apply to APIs held by PFICs for which a QEF election has been made, applies to tax years beginning after August 14, 2020.
any capital interest in the partnership [that] provides the taxpayer with a right to share in partnership capital commensurate with — In response to comments, the Final Regulations generally liberalize the approach taken by the Proposed Regulations regarding the capital interest exception. More specifically, the Proposed Regulations adopted a relatively rigid and narrow approach that generally required allocations to be made "in the same manner" to both the API Holder and "Unrelated Non-Service Partners" (defined later), apparently subject to very limited exceptions. By contrast, the Final Regulations replace the "same manner" test of the Proposed Regulations with a requirement to make allocations in "a similar manner" to both the API Holder and Unrelated Non-Service Partners. The Final Regulations further treat allocations as made "in a similar manner" if allocations and distribution rights for capital contributed by the API Holder are reasonably consistent with the allocation and the distribution rights for capital contributed by Unrelated Non-Service Partners. The term "Unrelated Non-Service Partner" is generally defined as a partner who does not (and did not) provide services in the partnership's trade or business and who is not related to any API Holder or any service provider with respect to the relevant trade or business. Practice note: The Final Regulations' adoption of a test that looks to whether the rights of API Holders and Unrelated Non-Service Partners are "similar" and "reasonably consistent" represents a welcome liberalization of the capital interest exception that should better accommodate standard market practices in the fund industry, as compared to the more rigid test in the Proposed Regulations. Similar to the Proposed Regulations, the Final Regulations clarify that an allocation to an API Holder will not fail to qualify for the capital interest exception solely because the allocation is subordinated to allocations made to Unrelated Non-Service Partners. Further, an allocation to an API Holder may still qualify even when (1) it is not reduced by the "cost of services" provided by the API Holder or a related person to the partnership (i.e., management fees or API allocations), or (2) the API Holder receives tax distributions, but other partners do not (provided such tax distributions are treated as advances on subsequent distributions). The Final Regulations retain the requirement in the Proposed Regulations that capital interest allocations must be clearly identified under both the partnership agreement and the partnership's books and records as separate and apart from allocations made with respect to an API. The Preamble to the Final Regulations (Preamble) indicated that the documentation requirements were a necessary corollary to the rule requiring capital interest allocations to be made in a similar manner between API Holders and Unrelated Non-Service Partners with a significant interest, because it shows that the partnership's Unrelated Non-Service Partners considered the partnership's allocations a valid return on their contributed capital. Despite requests from commentators, the IRS declined to grandfather or provide a transition period for existing partnerships to update their agreements for the stated reason that the capital interest exception contained in the Final Regulations now more closely aligns to standard industry practice and that, therefore, few partnership agreements would need to be amended. Practice note: Funds may want to implement procedures for ensuring the contemporaneous-partnership-books-and-records-documentation requirements are met and consider whether they need to amend their partnership agreements to address these rules. The Final Regulations generally retain the requirement that Unrelated Non-Service Partners must have made significant aggregate capital contributions to the partnership for allocations to an API Holder to qualify for the capital interest exception. For this purpose, Unrelated Non-Service Partners are treated as having made significant aggregate capital contributions provided that they possess 5% or more of the aggregate capital contributed to the partnership at the time the allocations are made (5% Test).4 The Final Regulations specify that the Unrelated-Non-Service-Partner requirement can also be applied on an investment-by-investment basis, or on a class-by-class basis, provided that the Unrelated Non-Service Partners have made significant aggregate capital contributions to the investment or class in question. Practice note: The requirement that Unrelated Non-Service Partners have made significant aggregate capital contributions to the partnership may be problematic for family offices and other closely held partnerships because there may not be any partners in the partnership that can satisfy the definition of Unrelated Non-Service Partners. The Proposed Regulations did not appear to require a capital contribution for allocations to an API Holder to qualify for the capital interest exception. By contrast, the Final Regulations appear to require a capital contribution. This change in the rules could affect many hedge funds. In the hedge fund industry, it frequently happens that a hedge fund general partner will leave part or all of its capital account attributable to previously allocated carried interest (commonly referenced in the hedge fund world as "incentive") invested in the fund and, going forward, earn a limited-partner-like return on those amounts. The Final Regulations create a rule that gives an API Holder qualifying capital account credit for certain items previously allocated to the API Holder; however, the rule is likely to be disappointingly narrow for many hedge funds. More specifically, the Final Regulations treat "API Gains" (i.e., LTCGs, as determined under the normal holding-period rules) that are reinvested by an API Holder in a Passthrough Entity (resulting either from an actual distribution and recontribution of the API Gain or the retention of the API Gain by the Passthrough Entity) as a contribution to the Passthrough Entity for a capital interest that may qualify for the Capital Interest Exception. The Final Regulations do not, however, provide a similar rule for unrealized gains allocated to an API Holder. Further, the rule in the Final Regulations also does not by its terms apply to taxable items other than API Gain, such as STCGs, dividends or interest income. It is not clear whether this omission was intentional. Practice note: The narrowness of the "deemed recontribution" rule for API Gains retained by a partnership is likely to be disappointing to many hedge-fund sponsors. Separately, one question raised by the "deemed recontribution" rule is whether it applies to gross API Gains or only to net API Gains (i.e., API Gains reduced by API Losses). The absence of any reference in the rule to "API Losses" or "net API Gains" suggests that the rule applies to gross API Gains, but it is unclear that this was intended. The Proposed Regulations contained a rule under which a taxpayer's capital account did not include, for purposes of the capital interest exception, any contributions directly or indirectly attributable to a loan or other advance made, or guaranteed, directly or indirectly, by (i) any other partner, (ii) the partnership, or (iii) a person related to either (i) or (ii). When repayments on the loan are made, taxpayers may include those amounts in their capital account as the repayments are made (provided that those amounts are not repaid with proceeds of another similarly sourced loan). Despite objections from commentators, the Final Regulations retain the same general rule5 that was in the Proposed Regulations. In response to comments, the Final Regulations add an exception to the general rule; the exception, however, is likely to be too narrow to cover many credit-support arrangements that are common in the fund industry. Under the exception in the Final Regulations, the previously-described general rule will not apply to a partnership contribution that is funded by a loan, if:
This exception is too narrow to cover many common arrangements. For example, it would not apply to any loans guaranteed by the management company (or any other person). It also appears that the exception would not cover a loan from the management company to the contributing partner unless (i) the management company were itself a partner in the partnership to which the contribution was made or (ii) the management company were related to a partner in the partnership (which many management company may not be). The drafters of the Final Regulations specifically declined to provide a grandfathering or transition rule for loan or guarantee arrangements already in place before the Final Regulations become effective; therefore, it appears that capital contributions attributable to such loans (to the extent the loans have not been repaid) may be tainted after the Final Regulations' effective date. Practice note: Funds that expect to recognize API Gain in tax years following the Final Regulations' effective date may want to consider whether revisions need to be made to their loan programs (including for loans already in place) to avoid tainting future gains. We continue to monitor developments in this area. The Proposed Regulations included a Lookthrough Rule that would have applied to the disposition of an API with a holding period of more than three years if there were lower-tier APIs with holding periods of no more than three years or passthrough entities that predominantly held capital assets with holding periods of no more than three years. In response to comments that the Lookthrough Rule in the Proposed Regulations was unduly broad and would be administratively burdensome for taxpayers, the Final Regulations have narrowed the circumstances in which the Lookthrough Rule will apply. The Lookthrough Rule in the Final Regulations applies if, at the time of a disposition of an API held for more than three years, either of the following is true:
For purposes of the first test, a substantial legal obligation to contribute money or property is an obligation to contribute a value that is at least 5% of the partnership's total capital contributions at the time of the API's disposition. Practice note: The "substantial legal obligation to contribute money or property" test may result in unexpected complications for many funds. For example, an increase in the size of evergreen funds appears to reset the required threshold continually (i.e., the required 5%-capital-interest-partner threshold becomes an ever-increasing number as the fund grows). The Lookthrough Rule's application to tiered structures also raises questions when certain tiers have no partners who are Unrelated Non-Service Partners. In addition, the Final Regulations do not state specifically whether deemed capital contributions attributable to API Gains allocated to an API Holder and retained by the partnership (as discussed previously) are treated as capital contributions for purposes of applying the Lookthrough Rule. IRC Section 1061(d) applies to transfers of APIs to certain related persons. The Proposed Regulations interpreted IRC Section 1061(d) as not only a gain recharacterization provision, but also a gain acceleration provision — in other words, the Proposed Regulations could have triggered short-term capital gain in related-party transfers that were otherwise eligible for nonrecognition treatment for US federal income tax purposes. In response to comments, the drafters of the Final Regulations modified the approach under IRC Section 1061(d). The Final Regulations state that IRC Section 1061(d) is not a gain acceleration provision, but merely a gain recharacterization provision. The Final Regulations, however, broadened the definition of "related person"7 for purposes of IRC Section 1061(d) by expanding the definition of "Passthrough Entity" to include trusts and estates. Thus, under the Final Regulations, IRC Section 1061(d) may apply to an otherwise taxable transfer of an API by an individual to a non-grantor trust for members of the individual's family.8 The Proposed Regulations initially broadened the definition of a "transfer" that "include[d], but [was] not limited to, contributions, distributions, sales and exchanges, and gifts."9 The Final Regulations narrowed the definition of a "transfer." To this end, the Final Regulation Section 1.1061-5(b) defines a "transfer" to mean "a sale or exchange in which gain is recognized by the Owner Taxpayer under chapter 1 of the Internal Revenue Code." Thus, the Final Regulations make clear in an example that a gift of an API will not be a "transfer" for these purposes, as it is not a sale or an exchange (in the example, a gift of an API is made outright to the taxpayer's daughter, rather than in trust).10
The IRC Section 1061(d) Recharacterization Amount is the net LTCG from less-than-three-year assets if the partnership sold its assets for cash equal to the FMV of those assets in a fully taxable hypothetical sale transaction immediately before the Owner Taxpayer's transfer of the API; the amount excludes LTCG that is excluded from IRC Section 1061 (e.g., qualified dividend income). As a result of the newly added "lesser of" test, the amount of gain converted to STCG under IRC Section 1061(d) is capped at the total net LTCG gain that would otherwise have been recognized by the Owner Taxpayer under the Code. Practice note: The Final Regulations' interpretation of IRC Section 1061(d) as merely a gain recharacterization provision (and not a gain acceleration provision) is an important and welcome change. However, taxpayers may want to take note of the broadened scope of "related person" for purposes of IRC Section 1061(d) given the expanded definition of "Passthrough Entity." In addition, taxpayers should keep in mind that a gift or donation of an API may be a taxable transfer (and therefore within the scope of IRC Section 1061(d)) if the partner's share of partnership liabilities under IRC Section 752 exceeded the partner's tax basis in the partnership interest immediately before the transfer. The Final Regulations do not contain a specific exception for family offices. The Preamble states that the IRS continues to study whether additional guidance is needed in the family-office context. Certain aspects of the Final Regulations — most significantly, the requirement in the capital interest exception that Unrelated Non-Service Partners have contributed significant capital to the partnership — may adversely affect family offices. The Final Regulations include financial instruments and contracts whose value is determined by reference to the value of the partnership in the definition of an API. This may cause a management company's contracts to fall within the scope of IRC Section 1061. Thus, capital gain attributable to these contracts may be subject to IRC Section 1061. The Preamble notes that Treasury continues to study this issue and may provide additional guidance in the future. Passthrough Entities (including funds of funds, funds and fund GPs) must report IRC Section 1061 information to Owner Taxpayers on an attachment to the Schedule K-1, including:
When API Holders dispose of their API interest, funds may need to provide certain information about the disposition, including information necessary to apply the Lookthrough Rule or determine the Owner Taxpayer's IRC Section 1061(d) Recharacterization Amount. Penalties will apply if a Passthrough Entity fails to timely comply (e.g., IRC Section 6698, Failure to File Partnership Returns, and IRC Section 6722, Failure to Furnish Correct Payee Statements). The Final Regulations generally make the disclosure rules for real estate investment trusts (REITs), regulated investment companies (RICs) and PFICs optional. If a REIT, RIC or PFIC for which a QEF election were made does not satisfy the reporting requirements, however, the entire capital gain dividend or QEF capital gain inclusion would be treated as one-to-three-year capital gain under IRC Section 1061. Additionally, funds must report certain IRC Section 1061 mandated information not only to their API Holders and Passthrough Entities, but also to the IRS. Practice note: Funds will need to report separately greater-than-three-year gains and greater-than-one-year gains from PFICs, REITs and RICs. The Final Regulations continue to adopt a hybrid approach to allocations made with respect to APIs, referenced as the "Partial Entity Approach." More specifically:
Under the Partial Entity Approach, funds will need to pass through API gains and losses to their ultimate beneficial owners (i.e., individuals, estates and trusts), who will perform the netting and determine the amount of LTCG that is recharacterized as STCG, if any. In applying IRC Section 1061 to gain on the sale or exchange of an asset, the Final Regulations retain the rule that the relevant holding period is that of the direct owner in the asset that is disposed of (subject to the Lookthrough Rule).11 Under the statute, APIs held directly or indirectly by corporations are not subject to IRC Section 1061 (the Corporation Exception). Treasury has taken the position that the Corporation Exception does not apply to APIs owned by S corporations (see Notice 2018-18) or PFICs for which a QEF election has been made (see the Proposed Regulations). The Final Regulations apply the rule excluding S corporations from the Corporation Exception to tax years beginning after December 31, 2017. The Final Regulations also apply the rule excluding a PFIC for which a QEF election has been made from the Corporation Exception to tax years beginning after August 14, 2020. The Final Regulations track the statutory language for the exception for employees of entities that are not engaged in an ATB. Practice note: This exception is generally interpreted as applying to persons receiving profits interests for providing services to PE-backed portfolio companies engaged in operating trades or businesses. The Final Regulations follow the Proposed Regulations by including an exception for third-party, non-service-provider purchasers of APIs. The Final Regulations generally follow the approach taken in the Proposed Regulations, with a few non-substantive clarifying changes. Under this exception, an API will cease to be treated as an API if it is purchased by a person who does not currently and has never provided services in the relevant ATB, is unrelated to any service provider and acquires the API for FMV. After the issuance of the Proposed Regulations, commentators had requested clarification on the application of this exception to lower-tier APIs. However, Treasury declined to include rules applying the exception in the tiered partnership context in light of the complexity that would have been involved. Practice note: This exception is generally expected to permit certain unrelated institutional investors to acquire interests in the general partner entities without creating any adverse consequences under IRC Section 1061, subject to the discussion later under fund-industry-specific takeaways. This exception does not appear in the statute. Thus, taxpayers who do not want to apply the Final Regulations consistently to all subsequent tax years will be unable to avail themselves of this exception in tax years preceding the effective date of the Final Regulations. Given that Treasury declined to provide any guidance as to how this exception applies in the tiered-partnership context, taxpayers will need to consider what approach to take. The Final Regulations retain the rules from the Proposed Regulations on certain types of income that are not subject to recharacterization under IRC Section 1061. These items include IRC Section 1231 gains, IRC Section 1256 gains and qualified dividend income. In addition, other gains that are characterized as short-term or long-term without regard to holding period rules under IRC Section 1222 are also excluded from IRC Section 1061 (e.g., capital gains and losses identified as mixed straddles under IRC Section 1092(b) and some of its regulations). However, installment sale gains may be subject to IRC Section 1061, even if the sale took place before IRC Section 1061's effective date. The Final Regulations take the same approach for property distributions made with respect to an API as the Proposed Regulations. The distribution of property from a partnership to an API Holder does not accelerate gain under IRC Section 1061 or the Final Regulations. However, the property distributed to the API Holder remains subject to IRC Section 1061. The API Holder takes a tacked holding period in such asset under the general rules governing partnership distributions of property. If the API Holder subsequently sells distributed property at a time when the property has a holding period of three years or less, the resulting gain will be subject to recharacterization under IRC Section 1061. This is important for individuals who might consider donating appreciated property to a tax-exempt organization. To the extent the appreciated property came to the donor from an API distribution and was held three years or less, the fact that the property would have been STCG in the hands of the donor means that the donation is limited to basis. Therefore, to secure an FMV deduction, the greater-than-three-year holding period needs to be met. The Final Regulations finalized without significant modifications the Proposed Regulations' rule for determining the holding period of a partnership interest when the partnership interest consists in whole or in part of a profits interest. Under the new rule, the portion of the holding period to which a profits interest relates is determined based on the FMV of the profits interest at the time of the disposition of all, or part, of the interest (and not at the time that the profits interest was acquired). As discussed previously, the Final Regulations adopt the recharacterization provision, but not the acceleration of gains. This is welcome news for fund professionals in the context of wealth-transfer planning. Another taxpayer-friendly adoption is that the recharacterization (i) includes only LTCGs that were held three years or less and transferred, via sale or exchange, to a related person, and (ii) excludes from the definition of transfer any reference to contributions, distributions and gifts. The sale-or-exchange provision could also apply to non-grantor trusts or other non-disregarded entities. The Proposed Regulations had included this language. The Final Regulations also retain the favorable treatment of grantor trusts from the Proposed Regulations as entities that are disregarded as separate from their sole owners for IRC Section 1061 purposes. For taxpayers considering wealth-transfer planning, these favorable changes permit greater flexibility in the gift and estate tax context. Funds may find complying with the detailed reporting requirements under the Final Regulations challenging. In addition to tracking more-than-three-year gains, three-year-or-less gains, and "capital interest" gains or losses, funds will need to track other items in detail. For example, the Lookthrough Rule creates significant compliance burdens in the context of tiered partnerships. Obtaining the necessary information will place significant burdens on funds. For a related-party IRC Section 1061(d) transfer, the partnership must, upon request, provide certain information needed by Owner Taxpayer transferees to compute their IRC Section 1061(d) Recharacterization Amount. QEF LTCG inclusions may be eligible for LTCG treatment under IRC Section 1061, provided the QEF satisfies certain reporting requirements. Funds or other persons planning to invest directly or indirectly in PFICs should consider negotiating for the contractual right (including for investors in certain funds or fund of funds, in their side letters) to receive the additional information needed to comply with IRC Section 1061, and thereby avoid converting greater-than-three-year capital gains into one-to-three-year capital gains due insufficient information reporting.
If the required disclosure is made, the Owner Taxpayer may treat a capital gain dividend paid by a RIC or REIT as greater-than-three-year gain to the extent that the capital gain dividend is attributable to capital assets held for more than three years or to assets that are not subject to IRC Section 1061. The narrow exception adopted in the Final Regulations may not be helpful to junior PE deal professionals who receive loans funded by banks and guaranteed by the general partner or fund manager. As such, PE funds that utilize certain related-party loan programs (or related-party guarantees of third party loans) for their partners to fund capital contributions may want to consider whether to revise their loan arrangements (including for already existing loans). The Proposed Regulations did not contain any operative rules on "carry waivers."12 The Preamble to the Proposed Regulations, however, put taxpayers on notice that Treasury was aware of them and could challenge them on various grounds, including the partnership anti-abuse rule in Treas. Reg. Section 1.707-2 and the economic substance doctrine. The Final Regulations are silent on "carry waivers." However, it is unlikely that Treasury and the IRS have altered their view of these arrangements. The Final Regulations do not provide additional guidance on split holding periods related to add-on investments in portfolio companies structured as C corporations or partnerships. When making add-on investments, Funds should carefully analyze the tax consequences of different potential structures to avoid or mitigate potentially adverse holding period consequences that could result in additional STCG under IRC Section 1061. The general partner of a hedge fund may earn a limited-partner-like economic return on its partnership capital account attributable to prior incentive allocations (sometimes referred to as a return on "proprietary capital"). Unlike the Proposed Regulations, the Final Regulations appear to require an actual or "deemed" capital contribution for the capital interest exception to apply. The Final Regulations create a rule that gives an API Holder qualifying capital account credit for API Gains allocated to the API Holder. This means future gains on those API Gains would qualify for the capital interest exception. However, the rule does not apply to other items of taxable income or incentive allocated out of unrealized gains. In addition, the language as drafted appears to apply to gross API Gains (i.e., unreduced by any API Losses), but it is not clear that this was intentional. In certain cases, it may make sense for a hedge or credit fund to change its incentive allocation to a fee, depending on the particular facts. Whether this is beneficial for fund managers (and/or investors) will depend upon the particular circumstances of the fund, such as its trading strategy. A fee rather than an allocation may be more advantageous for managers with minimal unrealized income and mostly short-term capital gains. Additionally, other tax provisions may be relevant to this analysis, such as the current limitations on miscellaneous itemized deductions under IRC Section 212. The Proposed Regulations created concern that IRC Section 1061(d) would apply to certain transfers of partnership interests in common hedge funds, such as general-partner-to-limited-partner conversions.13 The Proposed Regulations took the approach that IRC Section 1061(d) was not only a gain recharacterization provision but also a gain acceleration provision. In addition, they contained an exception for IRC Section 721 contributions of APIs, but not for other nonrecognition transfers. That appeared to create a risk that general-partner-to-limited-partner conversions could be taxable under IRC Section 1061(d). Fortunately, under the approach in the Final Regulations, IRC Section 1061(d) will not apply to a general-partner-to-limited-partner conversion unless the conversion is otherwise a taxable event. According to press reports, the new administration is broadly reviewing recently released regulations. The Preamble notes that the IRS and Treasury continue to study several aspects of IRC Section 1061. The Final Regulations appear to have certain "glitches," which may have unintended consequences. Additional guidance under IRC Section 1061 may be forthcoming.
1 "IRC Sections" refer to Sections of the Internal Revenue Code of 1986, as amended from time to time. "Treas. Reg. Section" refers to the US Treasury Regulations promulgated under the Code. 2 REG-107213-18. See Tax Alert 2020-2026. 3 An "API" generally refers to any interest in a partnership that, directly or indirectly, is transferred to (or held by) an Owner Taxpayer or Passthrough Taxpayer for the performance of substantial services by the Owner Taxpayer, a Passthrough Taxpayer or any Related Person, including services performed as an employee, in any "applicable trade or business" (ATB). An ATB generally refers to certain specified investment activities and includes the actions taken by related persons, including combining activities occurring in separate partnership tiers or entities as a single ATB. 4 There is an exception for capital interest allocations in a tiered structure. Provided the test of "significant aggregate capital contributions by Unrelated Non-Service Partners" is satisfied at the level of a lower-tier partnership, it appears that the test need not be satisfied at the level of an upper-tier partnership holding an interest in the lower-tier partnership for allocations by the upper-tier partnership of capital interest income flowing up from the lower-tier partnership to satisfy the capital interest exception. 5 The Final Regulations made a change to the language in the Proposed Regulations — the Final Regulations refer to "a partner in the partnership" rather than "any other partner" ("directly or indirectly, results from, or is attributable to, any loan or other advance made or guaranteed, directly or indirectly, by the partnership, a partner in the partnership, or any Related Person with respect to such persons," emphasis added). This would mean certain interests funded by loans from persons related to the partner would be excluded from capital interest treatment. 6 The text of the Final Regulations itself is not totally clear on this point (i.e., that the loan may be from a person related to a partner). However, language in the Preamble indicates that this was what was intended. 7 For purposes of IRC Section 1061(d), a related person includes: (1) a person that is a member of the taxpayer's family within the meaning of IRC Section 318(a)(1); (2) a person that performed a service within the current calendar year or the preceding three calendar years in the relevant ATB to the API transferred by the taxpayer, and (3) a passthrough entity to the extent that a person described in (i) or (ii) above owns an interest, directly or indirectly, in the entity. 8 The Final Regulations clarify that a grantor trust is treated as a disregarded entity for purposes of the Final Regulations. 11 But see the discussion on distributed property from an API below under the heading "Property distributions." 12 A "carry waiver" generally refers to a transaction in which a carried interest holder waives its right to a carried interest distribution, and the accompanying allocation of taxable income, in exchange for the right to receive a potential future distribution and allocation of income from the partnership, contingent on the fund's earning sufficient future income to make the allocation. The income waived is generally of a character disadvantageous to the carried interest holder, such as gain from the sale of a capital asset held for three years or less. 13 In this context, the term "general-partner-to-limited-partner conversion" refers to a transfer of part of a general partner entity's interest in a fund to another partner in the entity or other affiliate, and the resulting conversion of that transferred interest from a general partner interest into a limited partner interest. Document ID: 2021-0291 | |||||||||||||||||||||||||
