On January 7, 2021, the IRS released final regulations regarding the taxation of carried interests under Section 1061 of the Internal Revenue Code (the Code). The final regulations retained many of the basic features described in the proposed regulations last summer, but with certain helpful revisions.
First, some background: Investment partnerships such as hedge funds and private equity funds typically compensate their fund managers by granting a right to future partnership profits. This partnership interest is commonly known as a “carried interest” or a “promote” and is usually not taxable to the fund manager upon receipt. Gain recognized by the fund from its investments and allocated to the fund manager is generally taxed at favorable long‑term capital gain rates.
In 2017, Congress enacted Section 1061 of the Code as part of the Tax Cuts and Jobs Act. Section 1061 generally extends the holding period required to qualify for long-term capital gain treatment from one year to three years with respect to gains related to an “applicable partnership interest” (API). An API is any interest in a partnership which is held by a taxpayer in connection with the performance of services in any applicable trade or business (ATB), defined generally as (A) raising or returning capital, and (B) investing in or developing specified assets. The definition of “specified assets” includes securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and interests in partnerships to the extent of the partnerships’ proportionate interests in any of the foregoing. Most investment partnerships will fall within this definition, and therefore a fund manager that receives a carried interest from an investment partnership will typically be subject to the rules of Section 1061.
Section 1061 addresses a wide variety of fact patterns, and the final regulations contain 166 pages of additional guidance. From a trust and estates perspective, the focus has historically been on Section 1061(d), which recharacterizes certain long-term capital gain as short-term capital gain when a taxpayer transfers an API to a related person. Notably, Section 1061(d) does not define “transfer” or otherwise limit its application to income-taxable transfers. Thus, the statute suggests that tax-free transfers of an API (e.g., a gift, bequest or a transfer to a grantor trust) are also subject to Section 1061(d), and the proposed regulations furthered this view by stating that a transfer does inclu de gifts and at least certain other transfers that are otherwise tax-free. This created a substantial amount of uncertainty, as it became unclear whether making a tax-free transfer of an API could somehow trigger unrealized built-in gain that is recharacterized as short-term gain. The final regulations resolved this issue favorably by stating that Section 1061(d) does not apply to nontaxable transfers. Treas. Reg. § 1.1061-5(b). Thus, transfers of carried interests via death or gift do not trigger Section 1061(d).
The final regulations generally apply to taxable years beginning on or after January 19, 2021. It remains unclear how President Biden plans to address carried interest taxation, but note that the tax plan that President Biden released prior to the election did propose to increase the maximum tax rate applicable to long-term capital gains and qualified dividends from 20% to 39.6%. Any change to the long-term capital gain rate would have a substantial impact on Section 1061 and carried interest planning in general. For starters, taxpayers might decide to dispose of capital assets before rates increase without realizing that some are actually subject to a three-year holding period. It is also important to note that one of the key benefits of carried interest is the fact that it is currently eligible for a maximum 20% long-term capital gains rate instead of today’s maximum 37% ordinary income rate. Should both of those rates increase to 39.6%, the benefit of carried interest would be substantially diminished. On one hand, this would lessen the sting of triggering Section 1061 in the first place. However, this might also push investment funds to devise new ways to compensate and incentivize their fund managers, which in turn would lead to new tax planning opportunities.