On July 31, the IRS released proposed Treasury Regulations (the “Proposed 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.
Highlights of the Proposed Regulations
The Proposed Regulations resolve a number of questions:
Gains attributable to capital contributions by a general partner are not subject to Section 1061, provided certain requirements are satisfied;
- The three-year holding period is only applicable to sales of property, it does not apply to income treated as capital gains by virtue of a statute, such as qualified dividend income or Section 1256 gain;
- Property distributed to a general partner in-kind remains subject to Section 1061 until it has been held for more than three years (taking into account the holding period of both the partnership and the general partner); and
- Applicable partnership interests held by a Subchapter S corporation or a passive foreign investment company (“PFIC”) are subject to Section 1061.
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 “contributed capital exception”).
The operation of the contributed capital exception was somewhat unclear in respect of a general partner interest because it was uncertain whether a general partner interest could be an applicable partnership interest with respect to the incentive allocation and eligible for the contributed capital exception in respect of capital contributed by the general partner to the partnership. This uncertainty had significant ramifications for fund managers that reinvested their incentive allocation through their general partner entities.
The Proposed Regulations provide that allocations of capital gain to a holder of an applicable partnership interest will be treated as a “capital interest” which is exempt from Section 1061 if:
- the allocations are based on the relative capital accounts of the partners receiving the allocation and the terms, priority, type and level of risk, rate of return, and rights to cash or property distributions during the partnership’s operations and on liquidation are the same;
- the allocations are made in the same manner to the holder of the applicable partnership interest and unrelated investors;
- the allocations are made to unrelated investors with a capital account balance of at least five percent of the partnership’s capital account balances; and
- the allocations are clearly identified both under the partnership agreement and on the partnership’s books and records as separate and apart from allocations made to the manager with respect to its applicable partnership interest, and both the partnership agreement and the partnership’s books and records clearly demonstrate that the above requirements have been met.
The Proposed Regulations provide that a waiver of the management fee (and likely an incentive allocation) for the capital interest will not be taken into account for the purposes of making the above determinations. However, certain other features typically associated with an investment by a fund manager or its employees (such as liquidity) could potentially violate the above requirements.
Provided that a fund manager can satisfy the above requirements, most capital contributions by fund managers and employees should be treated as capital interests. Beyond the simplest case of a capital contribution made by a fund manager or an employee, the application of the capital interest rules to reinvested incentive allocations is unclear. It appears that reinvestments of realized gains from an incentive allocation may be treated as a capital interest. The treatment of unrealized gains is less clear. It is hoped that the final regulations will provide further clarity on this point.
The capital interest provisions will likely be the subject of extensive comments from industry and will possibly be revised and clarified prior to the Proposed Regulations being finalized.
Character of Certain Items
By its terms, Section 1061 operates by extending the holding period required for capital gain to be treated as long-term capital gain; it does not recharacterize other income treated as long-term capital gain as short-term capital gain or ordinary income. Prior to the issuance of the Proposed Regulations, it was an open question as to whether the IRS would attempt to use its regulatory authority to extend Section 1061 in this manner.
For example, dividends from U.S. domestic corporations and certain foreign corporations are taxed at long-term capital gain rates provided certain holding period and other requirements are met. Under Section 1256 of the Internal Revenue Code, regulated futures contracts are “marked to market” for U.S. federal income tax purposes at the end of each taxable year and any gain or loss thereon is treated as 60% long-term capital gain and 40% short-term capital gain.
The Proposed Regulations do not extend Section 1061 to these types of income items. This is welcome news for funds that invest in commodities or other instruments subject to Section 1256.
Distributions In Kind
On its face, Section 1061 did not change the long-term capital gain holding period for property distributed in-kind by an investment partnership. For example, it was unclear whether the three-year holding period applied to a situation where a general partner was owed $100 of incentive allocation and a fund distributed $100 of securities in kind to the general partner in satisfaction of that obligation.
Under the Proposed Regulations, where property is distributed by a partnership with respect to an applicable partnership interest, any gain realized by the distributee partner with respect to the distributed property remains subject to the three-year holding period rules in the hands of the distributee partner.
Use of S Corporations and PFICs to Avoid Section 1061
By its terms, Section 1061 does not apply to an applicable partnership interest held by a “corporation.” Some managers have considered restructuring their operations to insert a Subchapter S corporation or a PFIC into their structure to directly or indirectly hold the general partner interest in their fund.
In Notice 2018-18, the IRS notified taxpayers that Treasury Regulations issued under Section 1061 would provide that a Subchapter S corporation was not a “corporation” for purposes of Section 1061. Not surprisingly, the Proposed Regulations adopt the holding of Notice 2018-18 with respect to S corporations. This provision is effective for taxable years beginning after December 31, 2017.
The Proposed Regulations also provide that Section 1061 will apply to an applicable partnership interest held by a PFIC in which a U.S. shareholder has made a “qualified electing fund” election. This provision is effective as of the date the Proposed Regulations are published in the Federal Register.
Special Allocation Provisions
After the enactment of Section 1061, some funds have included provisions in their governing documents that would permit a general partner to waive a portion of its incentive allocation in the early years of a fund’s operation (which allocation may consist of three-year or less capital gains) and increase the amount of an incentive allocation by the waived amount in later years of a fund’s operation (which amount may consist of more than three-year capital gains).
According to the Preamble to the Proposed Regulations, the IRS will closely scrutinize so called “fee waiver” provisions and adds that such arrangements may not be respected under Section 707 of the Internal Revenue Code1 or the economic substance and substance over form doctrines. Given potential IRS scrutiny, fee waiver provisions should be carefully drafted.
Pre-2018 Unrealized Gains
The Proposed Regulations do not contain a transition rule with respect to unrealized gains accrued prior to the enactment of Section 1061. Therefore, any gains recognized on or after January 1, 2018 with respect to an applicable partnership interest are subject to the three-year holding period unless an exception (such as the contributed capital exception) applies. It was hoped that the IRS would exclude economically accrued but unrealized gains of holders of applicable partnership interests as of December 31, 2017, but no such relief was included in the Proposed Regulations.
Transfers of Interests to Related Persons
The Proposed Regulations provide that a transfer of an applicable partnership interest to a “Section 1061(d) Related Person” is generally a taxable event for the holder, even if such a transfer would otherwise not be a taxable event. Gain recognized on the transfer is treated as short-term capital gain to the extent that the gain that would be realized on a disposition of partnership property and allocable to the applicable partnership interest is attributable to property held by the partnership for three years or less. For example, a gift of an applicable partnership interest to a taxpayer’s child would be a taxable transaction under the Proposed Regulations.
Effective Date
Except with respect to the provisions related to S corporations and PFICs discussed above, the Proposed 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 Ronald P. Cima (212-574-1471), Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210), Brett R. Cotler (212-574-1269) or Tyler Combest (212-574-1472).
