On January 7, 2021, the Internal Revenue Service (the “IRS”) and the U.S. Department of the Treasury (the “Treasury”) issued final regulations[1] (the “Final Regulations”) providing guidance on Section 1061 of the Internal Revenue Code (the “Code”).[2] The Final Regulations modify the proposed regulations[3] (the “Proposed Regulations”) that were released in July of 2020. We previously discussed the Proposed Regulations with a series of “Key Takeaways” in our client alert published here. This post highlights certain changes made to the Proposed Regulations, and certain important provisions of the Proposed Regulations that remain unchanged in the Final Regulations.

In general, Section 1061 requires a three-year holding period for an investment fund manager’s share of capital gains earned through a fund to be eligible for the lower tax rates applicable to long-term capital gain.[4] This is a departure from the one-year holding period that is typically required for long-term capital gain treatment. The Proposed Regulations provided some guidance on the application of Section 1061; however, many of the provisions in the Proposed Regulations were unclear or unworkable and were criticized by commentators.

The Final Regulations are generally helpful to taxpayers, except with respect to allocations of unrealized gain, as discussed below. However, some questions remain unresolved and fund managers should continue to exercise care in interpreting and applying the Final Regulations. As discussed further below, the majority of the provisions will not be effective until at least January 1, 2022, allowing fund managers some time to prepare and plan. However, taxpayers are allowed to apply the Final Regulations prior to that date if they are applied consistently.[5]

Changes Introduced by the Final Regulations

Expansion of the Capital Interest Exception

Section 1061 applies to an applicable partnership interest (an “API”) held by or transferred to a taxpayer in connection with the performance by that taxpayer (or a related person) of substantial services in an applicable trade or business.[6] Section 1061 provides an exception for gain with respect to “capital interests” (generally understood to mean gain earned with respect to invested capital). The Proposed Regulations narrowly defined the scope of this exception, but the Final Regulations provide more flexibility.

Under the Proposed Regulations, the capital interest exception applied only to allocations in respect of a fund manager’s capital if those allocations were made in the “same manner” as allocations made to other unrelated non-service partners with a “significant” aggregate capital account balance in a fund (defined as at least 5% or more of the aggregate capital account balances of the partnership).[7] An allocation would be considered to be made in the “same manner” if the allocation were based on the relative capital account balances of the partners and the terms, priority, type, level of risk, rate of return and rights to cash or property distributions during the partnership’s operations and liquidation were the same.[8]

This approach was unworkable for managers of many closed-end private investment funds because it was unclear the extent to which differences in allocations and distributions between fund managers and other partners may violate the “same manner” requirement. Second, many partnership agreements use so-called “targeted allocation” provisions rather than allocating items in accordance with the partners’ respective capital account balances, a requirement under the Proposed Regulations. Lastly, the Proposed Regulations seemed to provide no flexibility for situations where allocations and distributions are made on a “deal-by-deal” basis or other than with respect to a partner’s entire interest in a partnership.

The Final Regulations replace the “same manner” requirement with a “similar manner” requirement, where allocation and distribution rights with respect to fund managers’ capital interests must now be “reasonably consistent” with such rights applicable to limited partners with a “significant” aggregate capital account balance in a fund (still defined as at least 5% or more of the aggregate capital account balances of the partnership).[9] The similar manner test may be applied on an investment-by-investment basis or on the basis of allocations made to a particular class of interests.[10] Under the Final Regulations, as under the Proposed Regulations, capital interest allocations must be clearly identified both under the partnership agreement and on the partnership’s contemporaneous books and records as separate and apart from allocations made to a fund manager with respect to its API.[11]

Finally, the Final Regulations explicitly confirm that a fund manager’s capital interest will not be ineligible for the capital interest exception solely because that fund manager is not charged management fees or carried interest, or because a fund manager has a right to receive tax distributions but unrelated non-service partners do not have such a right, so long as such distributions are treated as advances against future distributions.[12] The Final Regulations leave open whether certain other differences in economic terms, such as a disproportionate allocation of certain expenses (such as placement agent fees), or lock-ups and redemption rights in hedge funds, would disqualify a capital interest from benefitting from the exception.

Treatment of Capital Interests Acquired with Loan Proceeds

Under the Proposed Regulations, any loan or other advance made or guaranteed, directly or indirectly, by any partner, the partnership or any person related to another partner or the partnership, that is used to fund the acquisition of a fund manager’s capital interest would disqualify the interest from the capital interest exception.[13] These disqualified arrangements could include a loan from a management company to the general partner or individual members of the general partner to fund capital commitment amounts, a loan provided by the fund to the general partner or even a bank loan to an individual fund manager that is guaranteed by the management company or other partners. The rule applied to recourse and nonrecourse loans alike and applied without respect to a partner’s risk of loss in respect of a loan.

The Final Regulations retain the general rule that the capital interest exception does not apply to capital funded with the proceeds of a loan made or guaranteed, directly or indirectly, by the partnership, a partner or any person related to the foregoing.[14] However, the Final Regulations helpfully contain an exception to this general rule that allows capital interests of an individual service provider acquired with loan proceeds made, directly or indirectly, by any partner or any related person (other than the partnership) to still qualify for the capital interest exception so long as the individual service provider is personally liable for the repayment of such loan or advance.[15] The Final Regulations further provide that an individual service provider is considered personally liable for the repayment of a loan or advance made by a partner (or any related person, other than the partnership) if (i) the loan or advance is fully recourse to the individual service provider, (ii) the individual service provider has no right to reimbursement from any other person, and (iii) the loan or advance is not guaranteed by any other person.[16]

The retention of the prohibition of guarantees may continue to limit typical arrangements entered into by fund managers. For example, if an individual service provider employed by a fund manager borrows from a bank in order to fund the acquisition of its capital interest in the fund, and the fund’s management company guarantees the loan, the loaned proceeds fail to qualify for the capital interest exception under the Final Regulations even if the loan is fully recourse. However, it is possible that such an arrangement may be restructured in a manner that would allow the fund manager’s capital interest to satisfy the capital interest exception (for example, if the individual service provider funded its capital contributions with proceeds of a loan from a management company, which the management company acquired through a direct borrowing from a bank).

Given the complexity of the interaction of loans and guarantees in the context of the capital interest exception, fund managers should review carefully the specifics of any loan program that they use to fund capital commitments to their funds to ensure that such arrangements do not run afoul of the capital interest exception.

Treatment of Unrealized Gain

Some commentators had questioned whether, under the Proposed Regulations, unrealized gains that were allocated to a fund manager’s capital account as a result of a “book-up” or other revaluation event could be treated as capital of the fund manager for purposes of the capital interest exception (in other words whether a fund manager could get “credit” for economic gains in its capital account for purposes of the capital interest exception). Hedge funds typically allocate unrealized gains to their managers. If allocations of unrealized gains allowed the manager to qualify for the capital interest exception, future allocations in respect of the unrealized capital interest would not be subject to Section 1061.

The Final Regulations clarify that gains must be realized before a fund manager receives credit for purposes of the capital interest exception, and, therefore, a fund manager cannot get “credit” for unrealized gains.  The Final Regulations provide that any such realized gains will be treated as reinvested for these purposes whether such realized gains are distributed and recontributed to the fund by the fund manager or retained by the fund manager in the fund.

Transfers of APIs to Related Persons

Section 1061(d) generally provides that, if a taxpayer transfers, directly or indirectly, any API that has been held for three years or less, to a person related to the taxpayer (defined to include a taxpayer’s spouse, children, grandchildren, and parents, as well as colleagues), the transfer is taxable.[17] The Proposed Regulations broadly defined “transfer” in this context to include nonrecognition transactions such as gifts or contributions to partnerships. As a result, under the Proposed Regulations, the gift of a profits interest would accelerate the transferor’s gain.[18]

The Final Regulations helpfully clarify that Section 1061(d) does not accelerate gain on a transfer and applies only to transfers where gain is recognized.[19] Consequently, Section 1061(d) does not trigger the recognition of gain in otherwise tax-free transfers, such as contributions to partnerships or gift transfers that are often utilized in estate planning for fund managers. Nevertheless, any future realized gains in respect of such transferred APIs would remain subject to potential Section 1061 recharacterization.  

Lookthrough Rule for Certain API Dispositions

The Proposed Regulations treated the gain on the sale of an API as short-term capital gain in certain circumstances, even if the API had been held for more than three years.[20] The relevant holding period for a sale of an API (or pass-through entity holding directly or indirectly an API) is generally tested by reference to the holding period in that entity.[21] However, under the Proposed Regulations, if gain with respect to “substantially all” (80% or more) of the entity’s assets would be recharacterized as short-term under Section 1061 if disposed of (due to a holding period of three years or less), then gain on the sale of such API would be recharacterized as short-term even if the seller of the API had satisfied the three-year holding period generally required by Section 1061.[22]

Under the Final Regulations, the Lookthrough Rule has been significantly pared back, and replaced with an anti-abuse rule that is applicable only where, at the time of disposition of an API held for more than three years, (1) the API would have a holding period of three years or less if the holding period of such API were determined by excluding any period before which third-party investors have capital commitments to the partnership, or (2) a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under section 1061(a).[23]

Carry Waivers

In the Preamble to the Proposed Regulations, the IRS and the Treasury indicated they were aware of arrangements employed by fund managers to waive allocations of gain from a fund that would be treated as short-term capital gain pursuant to Section 1061, in order to be allocated future gain that could satisfy Section 1061’s three-year holding period. The Preamble to the Proposed Regulations included a warning that such arrangements may be subject to challenge on various grounds and should comply with generally applicable tax laws, including those that also apply to so-called “management fee waivers” (which we previously have discussed in a prior alert). The Final Regulations (including the Preamble), however, are completely silent on carry waiver arrangements. Nevertheless, careful planning should continue to be used when implementing such arrangements.

Guidance Consistent with the Proposed Regulations

APIs held by Corporations

Section 1061 provides an exception from the three-year holding period requirement for APIs held by “corporations”.[24] Consistent with previous IRS announcements,[25] and the Proposed Regulations, the Final Regulations confirm there is no exception for APIs held by S-corporations[26] or “passive foreign investment companies” (or “PFICs”) with respect to which the applicable owner has made a “qualified electing fund” election.[27]

Certain Income Not Subject to Recharacterization

The Final Regulations retain the rule in the Proposed Regulations that Section 1061 does not apply to (1) “qualified dividend income,”[28] (2) Section 1231 gains (generally, gain from the sale of real property and depreciable personal property used in a trade or business and held for over one year),[29] (3) gains characterized as long-term without regard to the holding period rules defined in Section 1222[30] (which include gains characterized under the mixed straddle rules), or (4) “mark-to-market gains” under Section 1256[31] (generally, gain from certain futures and options contracts).

Distributions of API Property

Stock of a portfolio company that a fund distributes to a fund manager continues to be subject to Section 1061. The Final Regulations confirm that a fund manager needs to continue to hold such shares following a distribution until the three-year holding period under Section 1061 has been met in order to obtain long-term capital gains treatment upon an ultimate sale of such stock.[32]

Effective Dates

The Final Regulations generally apply to tax years beginning on or after the date the Final Regulations are published in the Federal Register, and will therefore apply to taxpayers with a calendar tax year beginning January 1, 2022.[33] Taxpayers are allowed to apply the Final Regulations prior to that date, if they are applied consistently.[34] Consistent with the Proposed Regulations, the rules for partnership interests held by S-corporations are effective for tax years beginning after December 31, 2017 (the effective date of Section 1061),[35] and the rules for partnership interests held by PFICs that have made a QEF election are effective for tax years beginning after August 14, 2020.[36]

Potential for Further Changes

The Preamble to the Final Regulations foreshadows that additional Section 1061 guidance could be released. The IRS flagged several topics as remaining under study, and solicited additional comments in those areas. In particular, the impact of Section 1061 on the taxation of enterprise value for sales of partnership interests and management contracts remains under IRS study.[37]

Please consult with the members of your Proskauer tax team to further discuss the details of the Final Regulations and how they may apply to your particular circumstances.

[1] T.D. 9945.

[2] All references to “Section” are references to the U.S. Internal Revenue Code of 1986, as amended.

[3] Reg. 107213-18.

[4] Section 1061(a).

[5] Final Treas. Reg. 1.1061-1(b), 1.1061-2(c), 1.1061-3(f)(1), 1.1061-4(d), 1.1061-5(g), 1.1061-6(e).

[6] Section 1061(c).

[7] Prop. Treas. Reg 1.1061-3(c)(3)(ii), 1.1061-3(c)(4)(ii).

[8] Prop. Treas. Reg. 1.1061-3(c)(3)(i).

[9] Final Treas. Reg 1.1061-3(c)(3)(ii).

[10] Final Treas. Reg 1.1061-3(c)(3)(ii).

[11] Final Treas. Reg. 1.1061-3(c)(3)(ii)(B).

[12] Final Treas. Reg. 1.1061-3(c)(3)(ii)(A).

[13] Prop. Treas. Reg. 1.1061-3(c)(3)(ii)(C).

[14] Final Treas. Reg. 1.1061-3(c)(3)(v)(A).

[15] Final Treas. Reg. 1.1061-3(c)(3)(v)(A).

[16] Final Treas. Reg. 1.1061-3(c)(3)(v)(B).

[17] Prop. Treas. Reg. 1.1061-5(e).

[18] Prop. Treas. Reg. 1.1061-5(b).

[19] Final Treas. Reg. 1.1061-5(a).

[20] Prop. Treas. Reg. 1.1061-4(b)(9).

[21] Treas. Reg. 1.1061-4(a)(3)(ii).

[22] Prop. Treas. Reg. 1.1061-4(b)(9)(i)(C).

[23] Final Treas. Reg. 1.1061-4(A).

[24] Section 1061(c)(4)(A)

[25] Notice 2018-18.

[26] Final Treas. Reg. 1.1061-3(b)(2)(i); Prop. Treas. Reg. 1.1061-3(b)(2)(i).

[27] Final Treas. Reg. 1.1061-3(b)(2)(ii).

[28] Prop. Treas. Reg. 1.1061-4(b)(6)(iii).

[29] Prop. Treas. Reg. 1.1061-4(b)(6)(i).

[30] Prop. Treas. Reg. 1.1061-4(b)(6)(iv).

[31] Prop. Treas. Reg. 1.1061-4(b)(6)(ii).

[32] Final Treas. Reg. 1.1061-4(a)(4)(i)(C); Prop. Treas. Reg. 1.1061-4(a)(4)(i)(C).

[33] Final Treas. Reg. 1.1061-1(b), 1.1061-2(c), 1.1061-3(f)(1), 1.1061-4(d), 1.1061-5(g), 1.1061-6(e).

[34] Final Treas. Reg. 1.1061-1(b), 1.1061-2(c), 1.1061-3(f)(1), 1.1061-4(d), 1.1061-5(g), 1.1061-6(e).

[35] Final Treas. Reg. 1.1061-3(f)(2).

[36] Final Treas. Reg. 1.1061-3(f)(3).

[37] Final Treas. Reg. Part IV. A.

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Photo of Jeremy Naylor Jeremy Naylor

Jeremy Naylor is a partner in the Tax Department and a member of the Private Funds Group. Jeremy works with fund sponsors across asset classes, and their investors, in all tax aspects of private investment fund matters.

In addition, Jeremy works with his…

Jeremy Naylor is a partner in the Tax Department and a member of the Private Funds Group. Jeremy works with fund sponsors across asset classes, and their investors, in all tax aspects of private investment fund matters.

In addition, Jeremy works with his fund sponsor clients in designing and implementing carried interest plans and other compensation arrangements for the general partners of private funds.

Jeremy also advises U.S. and non-U.S. institutional investors, governmental investors, pension trusts and other tax-exempt organizations in their investments in private funds and joint ventures.

He also frequently represents secondary fund managers in connection with the tax aspects of their business, including fund formation, secondary transactions (including restructurings and private tender offers), primary investments and co-investments.

Jeremy also advises on M&A transactions involving his investment management clients, including minority sale transactions, preferred financing and control transactions.

Jeremy has significant experience structuring inbound investment in U.S. real estate by non-U.S. investors. In addition, Jeremy has significant experience in structuring domestic and cross-border mergers and acquisitions, advising on capital markets transactions and equity compensation arrangements.

Jeremy is a frequent speaker at industry conferences related to private investment funds, including the Merrill Lynch Private Equity and Venture Capital CFO Conference and the Practising Law Institute’s series on international tax. In addition, Jeremy frequently participates in webinars and provides other thought leadership in print media related to changes in the tax laws and their impact on private fund managers.

Photo of Amanda H. Nussbaum Amanda H. Nussbaum

Amanda H. Nussbaum is the chair of the Firm’s Tax Department as well as a member of the Private Funds Group. Her practice concentrates on planning for and the structuring of domestic and international private investment funds, including venture capital, buyout, real estate…

Amanda H. Nussbaum is the chair of the Firm’s Tax Department as well as a member of the Private Funds Group. Her practice concentrates on planning for and the structuring of domestic and international private investment funds, including venture capital, buyout, real estate and hedge funds, as well as advising those funds on investment activities and operational issues. She also represents many types of investors, including tax-exempt and non-U.S. investors, with their investments in private investment funds. Business partners through our clients’ biggest challenges, Amanda is a part of the Firm’s cross-disciplinary, cross-jurisdictional Coronavirus Response Team helping to shape the guidance and next steps for clients impacted by the pandemic.

Amanda has significant experience structuring taxable and tax-free mergers and acquisitions, real estate transactions and stock and debt offerings. She also counsels both sports teams and sports leagues with a broad range of tax issues.

In addition, Amanda advises not-for-profit clients on matters such as applying for and maintaining exemption from federal income tax, minimizing unrelated business taxable income, structuring joint ventures and partnerships with taxable entities and using exempt and for-profit subsidiaries.

Amanda has co-authored with Howard Lefkowitz and Steven Devaney the New York Limited Liability Company Forms and Practice Manual, which is published by Data Trace Publishing Co.

Photo of Scott S. Jones Scott S. Jones

Scott S. Jones is a partner in the Tax Department and a member of the Private Funds Group.

Scott’s practice focuses on tax planning for private equity fund managers in connection with their fund-raising and internal organizational matters, as well as investment activities.

Scott S. Jones is a partner in the Tax Department and a member of the Private Funds Group.

Scott’s practice focuses on tax planning for private equity fund managers in connection with their fund-raising and internal organizational matters, as well as investment activities. In addition, he represents U.S. and non-U.S. investors in connection with their investments in venture capital funds, buyout funds, hedge funds and other investment partnerships. In this capacity, as well as in connection with advising private equity funds with respect to their investment activities, Scott regularly advises on international tax issues that arise with investments in the U.S. by non-U.S. investors (including non-U.S. investors subject to special U.S. tax treatment, such as governmental pension plans and tax-exempt organizations), as well as investments outside of the U.S. by U.S. persons.

He also has significant experience structuring tax-free and taxable mergers and acquisitions (including cross-border transactions), equity compensation arrangements and innovative financing techniques for investments in tax transparent entities such as partnerships, limited liability companies and Subchapter S corporations.

Photo of David S. Miller David S. Miller

David Miller is a partner in the Tax Department. David advises clients on a broad range of domestic and international corporate tax issues. His practice covers the taxation of financial instruments and derivatives, cross-border lending transactions and other financings, international and domestic mergers…

David Miller is a partner in the Tax Department. David advises clients on a broad range of domestic and international corporate tax issues. His practice covers the taxation of financial instruments and derivatives, cross-border lending transactions and other financings, international and domestic mergers and acquisitions, multinational corporate groups and partnerships, private equity and hedge funds, bankruptcy and workouts, high-net-worth individuals and families, and public charities and private foundations. He advises companies in virtually all major industries, including banking, finance, private equity, health care, life sciences, real estate, technology, consumer products, entertainment and energy.

David is strongly committed to pro bono service, and has represented more than 200 charities. In 2011, he was named as one of eight “Lawyers Who Lead by Example” by the New York Law Journal for his pro bono service. David has also been recognized for his pro bono work by The Legal Aid Society, Legal Services for New York City and New York Lawyers For The Public Interest.

Photo of Stephen Severo Stephen Severo

Stephen Severo is a partner in the Tax Department. Stephen represents corporate, private equity and investment fund clients in connection with all tax-related aspects of their businesses, including fund formation, secondary transactions, taxable and tax-free mergers and acquisitions, tax-free spin-offs, taxable divestitures, domestic…

Stephen Severo is a partner in the Tax Department. Stephen represents corporate, private equity and investment fund clients in connection with all tax-related aspects of their businesses, including fund formation, secondary transactions, taxable and tax-free mergers and acquisitions, tax-free spin-offs, taxable divestitures, domestic and cross-border bank financing arrangements, investments, partnerships and joint ventures, debt restructurings, securities issuances and REIT and other specialized real estate transactions. He provides tax advice and planning for U.S. inbound and outbound investments, including treatment of U.S. shareholders under the PFIC and CFC regimes, foreign tax credit issues, treaty issues and reporting obligations. Additionally, he provides ongoing federal income tax counsel to clients in connection with tax structuring and strategy to minimize tax liability and effective tax rate, improve tax efficiencies, and ensure proper tax treatment and reporting.

Prior to joining Proskauer, Stephen was an associate in the tax department of Cravath, Swaine & Moore LLP.

Photo of Brianna Reed Brianna Reed

Brianna Reed is an associate in the firm’s Tax Department and a member of the Private Funds Group.

Her practice focuses on tax planning for domestic and international private investment funds, including venture capital, hedge, secondary, funds-of-funds, and other investment partnerships. Brianna counsels…

Brianna Reed is an associate in the firm’s Tax Department and a member of the Private Funds Group.

Her practice focuses on tax planning for domestic and international private investment funds, including venture capital, hedge, secondary, funds-of-funds, and other investment partnerships. Brianna counsels sponsors on all types of fund-related transactions and operations, including:

  • fund formation and fund-raising;
  • fund structuring and internal organization;
  • carried interest and other compensation arrangements;
  • buy-side secondary transactions and sell-side secondary transactions;
  • fund restructurings; and
  • portfolio company investments.

She also counsels investors regarding various tax considerations as they invest  in private funds and co-investment vehicles. These clients include:

  • institutional investors;
  • non-U.S. entities;
  • tax-exempt organizations;
  • U.S. persons making investments outside of the U.S.; and
  • regulated investment companies.

Brianna’s pro bono work involves advising non-profit organizations on applying for and maintaining federal income tax exemption, and advocating on behalf of victims of domestic violence and abuse. She received Proskauer’s Golden Gavel Award for excellence in pro bono work in 2019.

Brianna serves on the Steering Committee of Proskauer’s Women’s Alliance. She was also one of a few women selected to be a Protégée for Proskauer’s Women Sponsorship Program, an initiative for high performing midlevel lawyers that champions emerging leaders.

Outside of Proskauer, Brianna is a member of the Taxation Law Section Council of the Massachusetts Bar Association, which educates lawyers in areas of tax law and provides leadership in state tax law changes. She was selected as a fellow for the Massachusetts Bar Association’s Leadership Academy Class of 2021-2022. Brianna is also active in volunteer activities involving educational initiatives.

Prior to joining Proskauer, Brianna was an associate at a premier law firm, where she maintained a broad tax practice, including advising on tax aspects of mergers and acquisitions and other complex business transactions. She also previously worked in the tax department of a major U.S. defense contractor.

Photo of Kaitlyn L. Flynn-Rozanski Kaitlyn L. Flynn-Rozanski

Kaitlyn Flynn-Rozanski is an associate in the Tax Department and a member of the Private Funds Group.