On November 3, 2021, the IRS issued (IR-2021-215) frequently asked questions (FAQs) on tax reporting obligations of pass-through entities and "owner taxpayers" arising under IRC Section 1061 for certain partnership interests held in connection with the performance of services (i.e., carried interests).

The FAQs include worksheets and tables that pass-through entities and owner taxpayers must use for years to which the final IRC Section 1061 regulations apply or if they elect into the final regulations. An owner taxpayer is the person subject to tax on the IRC Section 1061 "recharacterization amount" and could be an individual, estate or trust.

The FAQs will be included in the next revision of Publication 541, Partnerships, which will be released in 2022, the IRS said.

Background

IRC Section 1061, enacted by the Tax Cuts and Jobs Act of 2017, generally imposes a more-than-three-year holding period requirement (instead of the usual more-than-one-year holding period requirement) for long-term capital gains treatment of capital gains from certain carried interests. 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 beneficial LTCG rates, as short-term capital gains currently taxed at the higher rates applicable to ordinary income.

On January 19, 2021, the IRS published final regulations under IRC Section 1061 (see Tax Alert 2021-0291). The final regulations are generally effective beginning in 2022 for calendar-year-end taxpayers but also apply to any newly formed pass-through entity formed on or after January 19, 2021. Pass-through entities or owner 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.

Reporting requirements

The IRS issued four FAQs with filing and reporting requirements for pass-through entities and owner taxpayers. The final regulations broadly define "pass-through entities" to include partnerships, trusts, estates, certain S corporations and passive foreign investment companies with respect to which a qualified electing fund (QEF) election has been made under IRC Section 1295. The FAQs also include an example for owner taxpayers.

Pass-through entities: Information that must be reported to applicable partnership interest (API) holders

Pass-through entities must attach Worksheet A to an API holder's Schedule K-1 for tax returns filed after December 31, 2021, when the pass-through entity is subject to the final regulations (i.e., for tax years beginning on or after January 19, 2021) or elects to apply the final regulations. The FAQ specifies which codes should be used for the various tax forms.

Pass-through entities that do not choose to apply the final regulations to tax returns filed after December 31, 2021, for tax years beginning before January 19, 2021, must attach a similar worksheet with the information required in Worksheet A and disclose whether that information was determined under the proposed regulations or another method.

Owner taxpayers: Calculating the amount treated as short-term capital gain

For tax returns filed after December 31, 2021, owner taxpayers that hold an API in the pass-through entity must use Worksheet B and two tables (listed in the FAQs) to determine the amount recharacterized from long-term gain to short-term gain. Worksheet B must be completed using the information supplied by the pass-through entity in the Schedule K and attached to the owner taxpayer's tax return.

Owner taxpayers that do not choose to apply the final regulations to tax returns filed after December 31, 2021, for tax years beginning before January 19, 2021, must attach a similar worksheet with the information required in Worksheet B and the tables and disclose whether that information was determined under the proposed regulations or another method.

Owner taxpayers: Reporting recharacterization amounts on Schedule D and Form 8949

If IRC Section 1061 does not apply, an owner taxpayer must report long-term and short-term API gains and losses on Schedule D and Form 8949, Sales and Other Dispositions of Capital Assets. Recharacterization amounts from Worksheet B are listed on Form 8949.

Owner taxpayers: Reporting collectibles gain and unrecaptured IRC Section 1250 gain

Pending government guidance, owner taxpayers that sell an API and recognize collectibles gain or loss or unrecaptured IRC Section 1250 gain (or if the pass-through entity reports the gain or loss) must use a reasonable method to compute the inclusion of collectibles gain and/or unrecaptured IRC Section 1250 gain in the recharacterization amount in Worksheet B. The FAQ gives a detailed explanation of how to report this information on Worksheet B.

Implications This IRS guidance sheds some light on IRC Section 1061 reporting in advance of the 2021 tax year season, which may be welcome news to funds to which the final IRC Section 1061 regulations apply. Private equity and alternative funds' general partners and certain other persons sharing in the fund's carry who may be subject to IRC Section 1061 may find the uniform reporting guidance helpful in order to better streamline IRC Section 1061 information needed to compute their recharacterization amount from their various fund investments. This guidance is also instructive for existing funds that will need to comply with the final regulations for tax year 2022 but may seek to restructure aspects of their carry/GP structure in advance of the effective date (i.e., by December 31, 2021, for pre-existing calendar-year-end taxpayers).

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