The IRS issued final regulations (T.D. 9945) under IRC Section 1061, which recharacterizes certain net long-term capital gains of a partner holding one or more applicable partnership interests (APIs) as short-term capital gains. 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 (i.e., generally speaking, certain investment funds). The final regulations will affect many 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.

The final regulations adopt with some revisions the proposed regulations (REG-107213-18) under IRC Section 1061 issued on July 31, 2020. The proposed regulations attempted to clarify how to apply IRC Section 1061 but left many open questions.

The final regulations clarify or revise several key aspects of the proposed regulations. The main changes address three main issues: (1) the capital interest exception, including the treatment of capital interests acquired with certain loan proceeds; (2) the "Lookthrough Rule" for certain API dispositions; and (3) transfers of APIs to IRC Section 1061(d) related persons.

Notable points of the final regulations include:

• A simplified rule in the context of the capital interest exception that acknowledges the commercial realities of alternative funds, applies consistently across both hedge and private equity funds, and looks to whether allocations are commensurate with capital contributed
• A more limited rule, especially helpful to junior deal professionals, that allows capital contributions funded with loan proceeds to qualify for the capital interest exception when, among other requirements, the individual service provider is personally liable for the loan
• Clarification that IRC Section 1061(d) applies only to sales or exchanges when long-term capital gain is otherwise recognized for income tax purposes and IRC Section 1061(d) would not apply to related-person transfers otherwise eligible for nonrecognition treatment under the Code
• A more modest look-through rule that is simplified and scaled back in the indirect context and generally applies only to certain abusive-type situations
• A simplified rule requiring taxpayers to take IRC Section 1061 into account for securities aggregation purposes (but declining to provide a specific method for doing so)
• Explicit treatment of API gain that is allocated by a partnership to an API holder and reinvested in the partnership (either via a contribution and recontribution, or via the retention of the API gain by the partnership) as a contribution to the partnership for a capital interest that may produce qualifying capital interest allocations going forward
• Retention of most of the proposed regulations' reporting rules
• Additional guidance on computing the IRC Section 1061(d) recharacterization amount of the "Owner Taxpayer" (i.e., an individual, trust or estate)
• A rule permitting taxpayers to adopt any reasonable method for apportioning the earnings and profits of a qualified electing fund (QEF) in the context of IRC Section 1061 until further guidance is issued

According to the regulations' Preamble, the IRS continues to study and solicit comments on many areas (e.g., the impact of IRC Section 1061 on the taxation of enterprise value for sales of partnership interests and management contracts). Additional guidance under IRC Section 1061 may be forthcoming.

Subject to limited exceptions, the final regulations apply to tax years beginning on or after the date final regulations are published in the Federal Register. For funds with a calendar tax year, these rules would generally be effective for tax year 2022. An Owner Taxpayer or a "Passthrough Entity" (i.e., generally a partnership, S corporation, trust, estate or QEF) may choose to apply the final regulations in their entirety to a tax year beginning after December 31, 2017, provided that they consistently apply the final regulations in their entirety to that year and all subsequent years (e.g., these regulations could be applied beginning in tax year 2020, assuming they are applied consistently).

A more detailed Tax Alert is forthcoming.