Today, the final carried interest regulations were published in the Federal Register. The final regulations generally adopt the proposed regulations that were issued in August 2020. However, there are a few noteworthy (and generally taxpayer favorable) modifications that taxpayers should be aware of.

As discussed previously, the carried interest provision was added by TCJA and recharacterizes certain net long-term capital gains attributable to carried interests as short-term capital gains. This alert highlights the following changes:

• Expansion of the capital interest exception
• Loan Proceeds Can Be Used to Fund a Capital Interest
• Reinvestment or Retained Capital Not Subject to Carried Interest 
• Look-Through Rule for Certain API Dispositions Narrowed 
• Certain Related Party Transfers Permitted
• Distributions of Property to a Holder of an Applicable Partnership Interest (API) 

Expansion of the Capital Interest Exception 

An important limitation in the proposed section 1061 regulations was an exception for capital gains allocated to “capital interests” held by taxpayers that also own APIs. However, the proposed regulations provided a narrow definition of the allocations that qualified for this exception, requiring:

• That the partnership agreement bases its allocations on the relative capital accounts of the partners receiving the allocations, 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 be the same as for non-service provider partnerships.

As a result, if finalized, it would have been difficult for many taxpayers in common structures to qualify for the exception. Fortunately, the final regulations expand the scope of allocations that would qualify for the capital interest exception. Specifically, an allocation qualifies for the capital interest exception if the allocation to the capital interest held by an API partner is determined and calculated in a similar manner as the allocations with respect to capital interests held by unrelated non-service partners who have made significant capital contributions. While the final regulations maintain the proposed regulation’s requirement that unrelated non-service partners must own at least 5 percent of the capital for their contributions to be considered significant, they do permit the 5 percent test to apply either on a class of equity basis or on a deal-by-deal basis. Additionally, the final regulations adopt the proposed regulations’ view that a capital interest can qualify for the capital interest exception even if the interest is not subject to management fees or carry allocations.

A&M Insight: The expansion of what constitutes a significant capital contribution by a non-service partner and the requirements of an allocation to be eligible for the capital interests exception are welcome changes to the regulations. As a result of these changes, traditional arrangements in private equity and hedge funds may be eligible for the capital interest exception, thereby reducing the application of the carried interest provision. Private equity and hedge fund managers are encouraged to consider the potential expansion of the exception in determining whether the carried interest rules apply to their allocations, as well as review their applicable partnership agreements to ensure that the allocations would qualify for the capital interest exception.

Loan Proceeds Can Be Used to Fund a Capital Interest 

Under the proposed regulations, a partner was not allowed to borrow funds from the partnership, another partner, or a related entity to make a capital contribution that would qualify as a capital interest for purposes of the capital interest exception. The final regulations reverse course and now permit such capital contributions to qualify for the capital interest exception, so long as the API partner is personally liable for the repayment. An API partner is personally liable for repayment if:

• The loan is fully recourse as to the individual API partner,
• The API partner does not have a right to reimbursement from any other person with respect to the loan, and
• The loan is not guaranteed by any other person.

Reinvestment or Retained Capital Not Subject to Carried Interest 

Under the proposed regulations, it was unclear whether reinvested carry would be subject to the section 1061 carried interest regime, or if the reinvestment would be viewed as a capital interest. The final regulations helpfully clarify that a reinvestment of an API gain will be treated as a capital interest.

A&M Insight: While the clarification is helpful, it is important to note that the unrealized API gain continues to be subject to section 1061.

Look-Through Rule for Certain API Dispositions Narrowed 

Under the proposed regulations, any time an API partner sold an API interest with more than a three-year holding period, it needed to look-through to the partnership’s holding period of its asset if at least 80 percent of the underlying assets of the entity had less than a three-year holding period (the Substantially All Test). As a result, this broad look-through rule would subject more gains to the section 1061 carried interest rules and convert what would otherwise be long-term capital gain or loss into short-term.

Fortunately, the final regulations eliminate the Substantially All Test and simplify the look-through rule to provide that an API needs to look-through to the partnership’s holding period of its assets if the API interest has a more than three-year holding period and either:

• The holding period of the API would be three years or less if the holding period began on the date that an unrelated non-service partner was legally required to contribute substantial money or property directly or indirectly to the passthrough entity to which the API relates, or
• The sale was a transaction or series of transactions that had a principal purpose of avoiding potential gain recharacterization under section 1061. 

Certain Related Party Transfers Permitted

Under the proposed regulations, an API partner that transferred its API to a related party, generally had to recognize its section 1061 carried interest gain, even if the transfer was part of a non-recognition transaction, by virtue of a hypothetical sale of all of the partnership’s property in a fully taxable transaction (the related party transfer rule). The final regulations narrow the application of the related party transfer rule by applying this rule only to a transaction in which gain is otherwise recognized. Effectively, this narrower rule converts the related party transfer rule into a recharacterization rule instead of an acceleration rule. 

Additionally, the final regulations provide that the amount recharacterized under the related party transfer rule is equal to the lesser of:

• The long-term capital gain recognized on the transfer and
• The net long-term capital gain from assets held for three years or less that the API transferor would have recognized if the underlying partnership had sold all of its assets in a fully taxable transaction for cash.

A&M Insight: The narrowing of the related party transfer rule is a welcome change. However, it is important to note that if the related party transfer rule does not apply because the API interest was transferred in a non-taxable transaction, then the recipient will be subject to section 1061, even if they themselves are not service providers. Therefore, the mere transference will not remove the API taint.

Distributions of Property to a Holder of an API 

Similar to the proposed regulations, the final regulations treat property that is distributed to the holder of an API as being subject to recharacterization if the property had a holding period of less than three years at the time of the distribution. However, the final regulations provide that once the distributed property has a holding period of more than three years, it is no longer subject to recharacterization under section 1061. Unlike other property, however, the final regulations provide that previously distributed API property that now has a more than three-year holding period is simply excluded from the section 1061 analysis, such that losses from the sale of previously distributed property which has a more than three-year holding period cannot offset gain from a property with shorter holding periods for purposes of determining whether the API holder has net long-term capital gain.

A&M Taxand Says

The final regulations retain the key limitations in the proposed regulations, which means that many of the structures that taxpayers were considering to address section 1061 remain viable. Additionally, the changes in the final regulations are generally taxpayer favorable and may provide additional avenues for taxpayers to reduce the impact of section 1061. In determining the implications of these regulations, it is important to note that while the effective date of the regulations is today, they only apply to taxable years beginning on or after today, unless taxpayers choose to retroactively apply them. Taxpayers should consult with their advisers to discuss how these regulations may apply to their interests.