The final regulations for the carried interest rules, published on Jan. 7, 2021, will have an impact on private equity (PE) and venture capital (VC) firm taxation and for the most part are more taxpayer friendly than previously proposed regulations.
Carried interest requirements generally apply to taxpayers who have an interest in a partnership providing services to investment-related businesses. Individuals who receive interest in any gains from this arrangement are generally treated as a partner in the partnership and the interest they receive is subject to the capital gains tax treatment.
Final regulations clarify the application of the carried interest Section 1061. Below is a summary of some of the key takeaways for PE/VC firms.
To briefly recap: The tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) introduced the three-year holding period requirement for carried interests under Section 1061 of the Internal Revenue Code (IRC). This three-year holding period requires partners who obtain carried interest in partnerships that conduct certain specified activities to hold the carried interest for at least three years before any "carry gains" from the sale of that investment become eligible for the long-term capital gains tax rate. Gains on the sale of such partnership interests that do not satisfy the three-year holding period are treated as short-term capital gains and have ordinary tax rates, which are significantly higher than the long-term capital gains rate.
The TCJA altered the timeline for when gains recognized in regard to an Applicable Partnership Interest (API) could qualify for long-term capital gains treatment. Starting in 2018, capital gains generated from selling assets with a less than three-year holding period and allocated to an API holder received the short-term capital gains treatment. This holding period requirement also extends partners that sell his/her API in external sale transactions.
As written, the changes to Section 1061 left some unanswered questions about the application of the rules to certain partnership interest circumstances which were to be addressed in future regulations. July 2020 proposed regulations addressed the types of partnership interests and businesses affected by the carried interest rules; how short-term capital gain (under the carried interest rules) is calculated; transfers of partnership interests to related parties; and reporting requirements. The proposed regulations did not conclude whether or not carried interest waivers would be respected. They also raised additional uncertainties and impractical applications of the law in many typical PE/VC business arrangements.
In January 2021, the IRS put forth the final regulations on the tax treatment of carried interests. The basic structure of the proposed July 2020 regulations remains, but rules have become more clearly defined and reasonable.
Summary of Final Regulation Changes
The final regulations are effective for taxable years beginning on or after Jan. 19, 2021, and include modifications in four main areas:
- The capital interest exception, which is now easier to meet in that allocations need only be similar to those of other, unrelated capital interest holders.
- Treatment of capital interests acquired with loan proceeds is no longer automatically excluded from the capital interest exception.
- The look-through rule for certain dispositions of partnership interests is more administrable and no longer requires the seller to determine whether the partnership's assets satisfy a three-year holding period.
- Transfers of applicable partnership interests to related persons in a nontaxable transaction no longer accelerates gain recognition.
Implications for PE/VC
The final regulations clarify the applicability of Section 1061 by specifying that the carried interest regulations apply to individuals who raise capital or return capital and invest in qualifying assets. Excluded from the rules are singular events, such as a joint venture in real estate.
Under the final rules, capital interest exceptions will be somewhat easier to meet for PE/VC firms. Generally, a gain is eligible if it is determined similarly to the allocations on capital interests held by unrelated, non-service partners that have made significant capital contributions to the fund, or if allocations on the capital interest are separate and apart from allocations on the carried interest in the partnership agreement and contemporaneous books and records of the partnership. Notably the final regulations clarify that waivers of management fees and carry are generally disregarded under this test. While such gains might not have qualified for the exception under the language in the previously proposed regulations, the more common economic arrangements in private equity and hedge funds will now be eligible for the capital interest exception under the final regulations.
The final regulations limit the look-through rule to dispositions of an API interest held for more than three years only if:
- The holding period of the API interest would be less than three years if that period were deemed to have started on the date that unrelated non-service partners were obligated to contribute substantial capital to the relevant partnership, or
- Tthere is a principal purposes of avoiding Section 1061 recharacterization.
They also clarify that the look-through rule applies for dispositions of stock in S corporations and pedigreed passive foreign investment companies (PFICs) for which qualified fund elections are in effect for holding periods longer than three years. The application of the look-through rules will no doubt cause confusion and the need for additional guidance. Partial sales of APIs in particular can create unfavorable results and commentators have asked for additional guidance to allow specific identification of the interest sold.
The final regulations also eliminate the proposed rule that would have accelerated gain on the transfers of APIs to related persons. Such transfers, a common practice in estate planning, will only have Section 1061(d) applicability for gains that were already otherwise recognizable.
Generally speaking, new regulations go into effect 60 days after they are published in the Federal Register. In this case, the regulations would take effect for 2022 for calendar year taxpayers. However, the Biden administration has issued a standard regulatory freeze memo that could delay official publication pending their review. CBIZ & MHM are carefully monitoring the situation for updates and will provide more details as information becomes available.
Where Can I Learn More?
For more information on how the carried interest regulations affect private equity and venture capital firms, reach out to George Cobleigh or another team member.
Published on February 17, 2021