The IRS recently released final regulations on the three-year holding period requirement for “carried interests.” This three-year holding period was introduced in Section 1061 of the Internal Revenue Code (IRC), as part of the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA). Under Section 1061, the holder of certain types of partnership interests must satisfy this three-year holding period in order to obtain long-term capital gains treatment upon the sale or disposition of the interest. The final regulations generally retain the same framework as the proposed regulations, but make some notable improvements to a few key rules.


The final regulations replace the proposed regulations that were released in July 2020 (see earlier coverage here). A carried interest under these rules is an interest in partnership profits that is obtained in exchange for substantial services, where the partnership interest relates to an “applicable trade or business” (ATB). An ATB exists when the partnership’s activity consists of raising or returning capital, and the activity must also involve investing in or developing specified assets (such as real estate). A carried interest is also known as an “Applicable Partnership Interest” (API), and the recipient of such an interest is often referred to as a service partner.

Four key rules were changed under the final regulations, each of which will be contrasted with the former proposed regulations and discussed in detail below.

Capital Interest Exception

Section 1061 establishes an exception to the three-year requirement for certain holders of APIs if the holder satisfies a capital interest test. Under the proposed regulations, an API holder satisfies the capital interest exception if:

  • The capital interest entitles the holder to partnership allocations that are made relative to the API holder’s IRC Section 704(b) capital account balance;
  • The terms for the allocations to the API holder and to unrelated non-service partners are identified in the partnership agreement as well as the partnership’s books and records, and the allocations must be clearly separate and apart from other allocations; and
  • The partnership makes allocations to all of the capital interest holders (the API holder as well as unrelated non-service partners) under the same terms, priority, type, level of risk, rate of return, and rights to cash or property distributions during the partnership’s operations and at the time of liquidation.

Modifications from the Proposed Regs

The final regulations modify these rules by relaxing the requirement that the allocations made to the API holder and unrelated non-service partners be the “same” (emphasized above). Under the final regulations, allocations made to API holders and non-service partners must instead be similar.

In order to be “similar,” the final regulations provide that allocations and distribution rights must be similar with respect to:

  • The amount and timing of capital contributed,
  • The rights to cash or property distributions,
  • The rate of return on capital contributed, and
  • The terms, priority, and type and level of risk associated with such capital

Capital Interests Acquired with Loan Proceeds

The proposed regulations addressed the exception for capital interests, in which case the API holder returns to being subject to the three-year holding period requirement of Section 1061. Under the proposed regulations, a partner’s capital account attributable to a capital interest is not permitted to include amounts contributed by the partner that were directly or indirectly funded from a loan or advance made or guaranteed by any other partner, the partnership, or a related person.

Modifications from the Proposed Regs

The final regulations retain this rule but limit its reach. Under the final regulations, a service partner’s capital interest may nevertheless include amounts contributed by the service partner that are funded from loan proceeds made by a partner, the partnership, or a related person if the loan recipient is personally liable for the repayment of the loan or advance.

Application of Lookthrough Rules on Sale of an API

The proposed regulations provide a special rule that would prevent an API holder from satisfying a three-year holding period for the partnership interest. Using a “lookthrough rule,” the proposed regulations would reclassify the API holder’s gain on the sale of the partnership interest if substantially all (80%) of the partnership assets (based on fair market value) do not meet the three-year holding period requirement. In this situation, the API holder would be deemed not to satisfy the three-year holding period despite the fact that the API holder actually held the partnership interest for more than three years. Furthermore, the proposed regulations extend this rule to an API held indirectly through tiered ownership, such that a sale of a partnership interest that is not itself an API would be tainted if the partnership owned an investment in a subsidiary partnership.

Modifications from the Proposed Regs

The final regulations back off from these harsh results considerably. Although a lookthrough rule is retained in principle, the “substantially all” test is removed under the final regulations. Instead, the holder must re-determine the holding period to exclude any time when no other unrelated non-service partner has a legal obligation to make a substantial capital contribution directly or indirectly to the passthrough entity to which the API relates.

Transfers of an API to Related Persons

The last noteworthy change to the proposed regulations pertains to a questionable rule in the case of API transfers by the holder to a related person. Under the proposed regulations, a transfer of an API by the holder to a person related to the holder triggers immediate gain recognition on any built-in appreciation related to partnership assets that have been held less than three years. Even for transfers that would otherwise be nontaxable (like gifts), the proposed regulations would require this taxable treatment for the transferring partner, which would produce a short-term capital gain.

Modifications from the Proposed Regs

The final regulations thankfully abandon this rule, because it would require partners to recognize gains in situations where general tax principals would not require gain recognition. Instead, if a taxpayer transfers an API to a related party, the transferor will only re-characterize as short-term gain the amount of long-term gain that is actually recognized on the transfer. Specifically, the amount re-characterized under this rule is the taxpayer’s share of capital gain from assets held for three years or less that would have been allocated to the taxpayer with respect to the transferred carried interest if the partnership hypothetically sold such property. It is important to note that the API remains subject to the carried interest holding period rules in the hands of the related party recipient.


After careful examination of the final regulations, it is clear that the IRS has adopted a more taxpayer-friendly approach to the application of the carried interest rules. This will result in fewer taxpayers being subject to the three-year holding period requirement, and the reduced complexity will also make it easier for taxpayers to comply with the rules. For more information on these rules and planning techniques for carried interests please contact your local CBIZ tax professional.

Published on March 01, 2021