On January 7, 2021, the Internal Revenue Service (the “IRS”) and the Department of the Treasury released final regulations (the “Final Regulations”) implementing the provisions of Section 1061 of the U.S. Internal Revenue Code of 1986, as amended (the “Code”). Section 1061, which was enacted as part of the most recent U.S. tax reform in 2017, generally extends the holding period required to benefit from the favorable long-term capital gain treatment from one year to three years in certain cases. The Final Regulations generally retain the framework of the proposed regulations published on August 14, 2020 (the “Proposed Regulations,” which were covered in our earlier alert). However, the Final Regulations include a number of important revisions and clarifications. Fund sponsors should consider the possible implications of the Final Regulations to their funds including whether existing fund agreements should be revised.

In this alert, we provide a brief overview of the main rules under Section 1061 and highlight several of the most relevant revisions and clarifications included in the Final Regulations.

Section 1061 – Background

Congress enacted Section 1061 as part of the Tax Cuts and Jobs Act (the “2017 Tax Reform”). As mentioned, Section 1061 extends the holding period required to benefit from favorable long-term capital gain treatment from one year to three years in certain cases. In general, the three-year holding period applies to gain allocated to applicable partnership interests (“API”) held in connection with the performance of certain services, including, in particular, services of the type provided by fund managers in the private equity, hedge fund, real estate and family office sectors. The enactment of Section 1061 in such manner after decades of criticism aimed at financial sponsors and the corresponding preferential tax treatment attached to carried interest was generally viewed as a favorable outcome by the industry.

Section 1061 generally defines an API as an interest in a partnership transferred to or held by a taxpayer in connection with the performance of substantial services for the partnership in an “applicable trade or business” (“ATB”). An ATB is defined as any activity conducted on a regular, continuous, and substantial basis, through one or more entities, that consists of, in whole or in part, (1) raising or returning capital and (2) investing in or disposing of “specified assets,” identifying such assets for investment or disposition, or developing such assets. For these purposes, “specified assets” are defined as securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivatives contracts with respect to any of the foregoing, and an interest in a partnership to the extent of such partnership’s proportionate interest in any of the foregoing.

The Final Regulations

While the Final Regulations generally keep the framework of the Proposed Regulations, they do provide several important clarifications and simplifications to the applications of Section 1061.

• Capital Interest Exception. Section 1061 excludes from the scope of API those capital interests in partnerships that give the taxpayer a right to share in partnership capital based on (i) the basis of relative capital account balances of the partners, subject to certain exceptions for preferred returns and cost differences (such as reduced management fees) or (ii) the value of such interest subject to tax under Section 83 (the “Capital Interest Exception”). The Final Regulations adopt a more flexible approach for the implementation of the Capital Interest Exception. In particular, the Final Regulations apply the Capital Interest Exception if allocations are determined and calculated “in a similar manner” to allocations with respect to capital contributions by unrelated investors holding in the aggregate interests corresponding to 5% or more of capital contributions to the partnership. The Final Regulations clarify that certain typical differences in terms (such as tax distributions and no carried interest or management fees) would not disqualify an interest from the application of the Capital Interest Exception. In addition, the Final Regulations require that allocation with respect to capital contributions of partners and those with respect to API of the same partners are separately identified and that the provisions of the partnership’s agreement and its books and records reflect such separate allocation.

• Borrowing. The Final Regulations loosen the provision of the Proposed Regulations to provide that investments made by an individual service provider with borrowed capital may qualify for the Capital Interest Exception to the extent (i) such borrowing is fully recourse to the individual service provider, (ii) the individual service provider has no right to reimbursement from any other person, and (iii) such borrowing is not guaranteed by any other person.

• Holding Periods and the Look-Through Rule. The Proposed Regulations provide that gain from the sale of an API that is held for a period exceeding three years could nevertheless be recharacterized under Section 1061(a) based on a complex look-through rule. The Final Regulations narrow the application of the look-through rule. Pursuant to the Final Regulations, the holding period of an API would be determined under the look-through rule by excluding any period prior to the date that an unrelated investor is legally obligated to contribute substantial capital (at least 5% of the partnership’s total capital contribution) to the relevant partnership.

• Transfers of API to Related Person. Pursuant to the Proposed Regulations, transfers to related parties could result in short-term gain recognition even if the transfer was otherwise a non-recognition event. The Final Regulations limit the scope of Section 1061(d) such that it only applies to recharacterize (as short term) gain that is otherwise triggered with respect to a taxable transfer of APIs. In addition, the Final Regulations clarify that certain exceptions under the general rule of Section 1061(a) also apply with respect to related party transfers.

• Carried Interest Waivers. Following the enactment of the 2017 Tax Reform, practitioners considered the ability to use “carry waivers” as a possible technique to avoid the implications of Section 1061 and often incorporated such flexibility into governing fund documents. Such waivers permit sponsors to waive carry distributions (and avoid corresponding income allocations) on early gains (i.e., within the three-year period) in favor of subsequent distributions and allocations that are not subject to Section 1061. The preamble to the Proposed Regulations cautioned that attempts to “circumvent” Section 1061 through such waivers may be challenged by the IRS based on long-standing anti-avoidance doctrines. While the the Final Regulations do not address carry waivers, the warning previously made may still be applicable.

• Effective Date. The Final Regulations generally apply to taxable years beginning on or after the date of publication in the Federal Register (subject to certain exceptions for S corporations and PFICs).