On January 7, the IRS released final Treasury Regulations (the “Final Regulations”) interpreting the three-year holding period for long-term capital gains applicable to investment managers under Section 1061 of the Internal Revenue Code (“Section 1061”).
Section 1061
Section 1061, which was enacted as part of the legislation known as the Tax Cuts and Jobs Act of 2017, provides that a taxpayer’s distributive share of capital gains from an “applicable partnership interest” will be treated as short-term capital gains (which are taxed at higher ordinary income rates) to the extent such gains result from the sale or exchange of one or more assets held by the partnership for three (3) years or less.
An “applicable partnership interest” is an interest transferred to the taxpayer for the performance of substantial services involving developing or investing in certain investment assets, including stocks, securities, commodities and real estate. This definition covers general partner and special limited partner interests in private investment funds.
Section 1061 can cause a substantial amount of incentive allocation income (that had in the past been allocated to the general partner or special limited partner of an investment fund as long-term capital gains) to be treated as short-term capital gains. The highest marginal income tax rate applicable to short-term capital gains is 37%. Long-term capital gains are subject to a maximum tax rate of 20%.
The three-year holding period requirement of Section 1061 does not apply to the extent of investment professionals’ capital investments in their own funds. Such investments remain subject to the one-year holding period for long-term capital gains.
In July 2020, the IRS released proposed Treasury Regulations (the “Proposed Regulations”) interpreting Section 1061. Our memorandum regarding the Proposed Regulations is available here. The Proposed Regulations were the subject of substantial comments from the private funds industry and various comments were incorporated into the Final Regulations.
Highlights of the Final Regulations
The Final Regulations make substantial changes to the Proposed Regulations in several important areas:
- The exception to the three-year holding period for contributed capital has been simplified and undergone substantial favorable changes;
- Contributions of realized gains will qualify for the Capital Interest Exception, while it is clarified that unrealized gains will not so qualify;
- Transfers of applicable partnership interests to a related person in an otherwise tax-free transaction will not trigger immediate recognition of gain.
Contributed/Reinvested Capital
Section 1061 provides an exception to the three-year holding period for “any capital interest in the partnership which provides the taxpayer with a right to share in partnership capital commensurate with…the amount of capital contributed (determined at the time of receipt of such partnership interest)” (the “Capital Interest Exception”).
Under the Proposed Regulations, the Capital Interest Exception was limited in scope because allocations were required to be made based on relative capital accounts of the partners and “in the same manner” to the holder of the applicable partnership interest and unrelated investors.
As a result, it appeared that the Capital Interest Exception may have been unavailable for many private funds. For example, under the “same manner” requirement, it was unclear whether rights typically associated with an investment by a fund manager or its employees—such as a waiver of fees, liquidity rights, or tax distributions—could potentially violate the above requirements.
The Final Regulations greatly simplify this rule. Under the Final Regulations, an allocation of profits will be treated as being made with respect to a capital interest if:
- the allocation with respect to the capital interest “is determined and calculated in a similar manner” as allocations made to unrelated investors who have made significant aggregate capital contributions; and
- the allocations with respect to the capital interest are separate and apart from the allocations made to the applicable partnership interest and both the partnership agreement and the partnership’s contemporaneous books and records clearly demonstrate that the requirements of the capital interest exception are satisfied.
An allocation will be treated as being made in a “similar manner” based upon the following factors: “the amount and timing of capital contributed, the rate of return on capital contributed, the terms, priority, type and level of risk associated with capital contributed, and the rights to cash or property distributions during the partnership’s operations and on liquidation.” The fact that a capital interest is not charged a management fee or an incentive allocation is not taken into account in making this determination.
Provided that a fund manager can satisfy the above requirements, most capital contributions by fund managers and employees should be treated as capital interests. However, it is unclear how a partnership agreement can clearly reflect whether allocations meet the Capital Interest Exception. Partnership agreements may need to be updated for this provision.
Reinvestments of Incentive Allocations
The treatment of the reinvestment of an incentive allocation by a fund manager was unclear in the Proposed Regulations and was the subject of extensive industry comment.
The Final Regulations clarify that Section 1061 does not apply to a reinvestment of a realized incentive allocation in an investment partnership, provided that the reinvestment otherwise satisfies the Capital Interest Exception discussed above. This rule applies to both amounts that are actually distributed to a fund manager and reinvested in the fund as well as amounts which are simply retained in the capital account of the fund manager.
The above exception applies only to realized gains which are reinvested. Any gains arising from the reinvestment of unrealized incentive allocations are not eligible for the Capital Interest Exception and remain subject to Section 1061 until realized.
Transfers of Interests to Related Persons
The Proposed Regulations provided that a transfer of an applicable partnership interest to a “Section 1061(d) Related Person”1 was generally a taxable event for the holder, even if such a transfer would otherwise not be a taxable event. The Proposed Regulations therefore accelerated gain on such transfers (including, for example, gifts of such interests to a fund manager’s children and possibly transfers of limited partnership interests in a fund to certain partnerships).
In contrast, the Final Regulations do not impose immediate taxation on the transfer of an applicable partnership interest to a Section 1061(d) Related Person in an otherwise non-taxable transfer such as a gift. Rather, the Final Regulations provide that if an applicable partnership interest is transferred to a “Section 1061(d) Related Person,” the interest will remain subject to Section 1061(d) in the hands of the transferee.
This is a highly favorable development that should eliminate uncertainty regarding gifts to family members and transfers of applicable partnership interests to partnerships in which a principal of the fund manager is a partner.
Family Office Exception
Section 1061(b) provides that, to the extent provided by Treasury Regulations, Section 1061(a) shall not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third party investors. This exception is likely designed to apply to family offices.
In the Preamble to the Proposed Regulations, the IRS took the view that no additional regulations were necessary to make effective this exception. There were extensive industry comments on potential exemptions from Section 1061 for family offices. In the Preamble to the Final Regulations, the IRS requested additional comments on this potential exception.
Effective Date
The Final Regulations are generally effective for taxable years beginning after the date that they are published as Final Regulations in the Federal Register.
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For additional information on the Proposed Regulations, please contact Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Ronald P. Cima (212-574-1471), Daniel C. Murphy (212-574-1210), Brett R. Cotler (212-574-1269) or Tyler Combest (212-574-1472).
