January 7, 2021
BREAKING TAX NEWS | IRS issues final carried interest regulations expected to impact many alternative investment funds and their professionals
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:
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.