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IRS Releases Proposed Regulations on Section 1061 Carried Interest Provision

September 10, 2020

Attention investors…you will want to read up on changes to your investments that meet the definition of an “Applicable Partnership Interest” and how it could impact your tax bill.

The IRS has recently published proposed regulations addressing Section 1061 rules relating to “Applicable Partnership Interests”, which includes the much talked-about “carried interest”. Here are the details.

What is an “Applicable Partnership Interest?

The “Applicable Partnership Interest” was first unveiled in the sweeping 2017 Tax Cuts and Jobs Act under Section 1061. An interest in an partnership that is connected to the performance of ‘substantial services’ in a ‘regular, continuous, and substantial’ activity consisting of raising or returning capital, and either investing in or developing securities, commodities, real estate, or partnership interests is considered an “Applicable Partnership Interest” for the definition of Section 1061.

“Carried interest” is an example of an “Applicable Partnership Interest”. As our blog, Carried Interest Post TCJA: Impact on Private Equity covers, investors typically compensate private equity firms by paying a 2% annual fee on assets under management. Before the Tax Cuts and Jobs Act (TCJA) was passed, carried interest held for at least one year was taxed as a long-term capital gain, rather than ordinary income.

Depending on the investor’s tax bracket, long term capital gains are taxed at a rate of 0%, 15% or 20% whereas short term capital gains are taxed at your ordinary income tax rate (could be as high as 37%).

What’s new?

The proposed regulations confirm that any “Applicable Partnership Interest” held for less than three years will be taxed at ordinary rates, and long-term capital gain rates will apply for investments held for more than three years. The proposed rules do not apply to a number of types of income that qualify for long-term capital gain rates without reference to holding period rules, including Section 1231 gains.

Here are some other key takeaways:

The proposed regulations confirm that:

  • Once a partnership interest is subject to Section 1061, it remains subject to Section 1061, unless and until a specific exception applies or a third-party sale of the partnership interest has occurred
  • Section 1061 re-characterization applies to carried interests held by S corporations and expands this covered group to included certain PFIC entities
  • Certain types of income or gains are excluded from Section 1061, notably section 1231 gains and section 1256 market-to-market capital gains
  • A ‘capital interest’ generally does not include any portion acquired using a loan from the partnership, another partner or any related person

We will keep you posted on how this legislation fares. The proposed regulations will typically apply to taxable years beginning on or after the date published as final regulations.

Questions? Contact us.

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