Locke Lord QuickStudy: IRS Issues Carried Interest Guidance

On July 31, 2020, the Internal Revenue Service and the U.S. Treasury Department issued Proposed Treasury Regulations (the “Proposed Regs”) providing guidance under the “carried interest” rules of Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”).1 The Proposed Regs address a number of open questions regarding the scope and implementation of Section 1061 that remained following its enactment as a part of the 2017 Tax Cuts and Jobs Act, and provide additional computational and reporting rules as well as a new transition rule related to certain pre-enactment appreciation. Although the Proposed Regs generally will not be effective until they are issued in final form, certain provisions may at the election of taxpayers be relied upon currently. Taxpayers involved in enterprises that issue carried interests (e.g., private equity funds, hedge funds, real-estate funds, and energy funds) should carefully review the Proposed Regs.

Key Points of the Proposed Regs

1. The Proposed Regs confirm that once a partnership interest is subject to Section 1061 it remains subject to Section 1061 unless and until a specific exception applies.

 2. The Proposed Regs confirm the view of Treasury that Section 1061 recharacterization applies to carried interests held by “S corporations,” and further expand this covered group to include certain “PFIC” entities, in each case, notwithstanding the plain language of the statute. 

3. The Proposed Regs confirm that certain types of income or gains are excluded from Section 1061, notably Section 1231 gains and Section 1256 marked-to-market capital gains. 

4. The Proposed Regs adopt a narrow exception for “capital interests” held by service providers that may be difficult for some traditional structures to meet. For purposes of this 

exception, a “capital interest” generally does not include any portion acquired using a loan from the partnership, another partner, or any related person.

5. The Proposed Regs may recharacterize as short-term gain all or a portion of the gain on the sale ‎of a holder’s carried interest even if the holder held such interest for longer than three years based ‎upon certain look-through rules.‎

6. The preamble to the Proposed Regs potentially calls into question certain carried interest “waiver” techniques utilized to avoid the impact of Section 1061.

7. The Proposed Regs potentially treat transfers of a carried interest that would otherwise have been nontaxable (for example, a gift) to certain related parties as creating gain subject to current taxation.

Brief Overview of Section 1061

Section 1061 recharacterizes certain long-term capital gains as short-term capital gains (generally taxed at less favorable rates) when allocated to taxpayers that hold, directly or indirectly, an “applicable partnership interest” (an “API”), which is the Section 1061 term for what is often referred to as a carried interest. An API for this purpose is generally defined as a partnership interest that is transferred to or held by a taxpayer in connection with the performance of substantial services (by the taxpayer or a related party) with respect to an “applicable trade or business” (generally raising or returning capital and providing investment management services – an “ATB”). Section 1061 extends the holding period required to achieve long-term gains status for a covered disposition from one year (under current law for long-term capital assets)‎ to three years, thus requiring a longer investment period in order for the holder of an API to benefit from the long-term capital gains rates.

The On/Off Switch – What is an API?

The Proposed Regs provide that, once a partnership interest is classified as an API, it retains that status unless and until a specific exception to such treatment applies. Thus, absent such an exception, an API remains subject to the holding period rules of Section 1061 even if the holder of such API retires or otherwise ceases to provide services, the underlying ATB is discontinued, or the holder transfers the API. The Proposed Regs also provide additional detail regarding the determination of whether an ATB necessary for the creation of an API exists, including certain rules defining the level of activity required for an ATB and rules requiring the aggregation of the activities of certain related persons in determining whether such level of activity is met. Finally, the Proposed Regs expand the potential scope of API treatment by providing that certain financial instruments that do not constitute partnership interests for general income tax purposes could be treated as an API if the value of such instrument is determined in whole or in part by reference to the underlying partnership, thus foreclosing a potential end run around the Section 1061 rules.

Certain exceptions to API status are retained and further detailed upon by the Proposed Regs, including of import an exception for separate capital investments made by the API holder on the same terms as investors and an exception for interests transferred to an employee of a portfolio company owned by the issuer of the interest. The exception for separate capital investments clarifies certain open issues related to this exception that surrounded the initial enactment of Section 1061, including that (i) subordination to investor returns and/or exclusion from reduction for certain costs of services (for example, management fees) for such a capital investment will not prevent it from being treated as being on the same terms as the other investors and (ii) such a capital investment generally may not be funded through loans or other advances made or guaranteed, directly or indirectly, ‎from the underlying partnership or another partner (or certain related persons), thus eliminating ‎one ‎strategy that certain taxpayers attempted to use to fall within this exception.‎ Overall, the Proposed Regs provide a somewhat narrow view of what qualifies as a capital investment for this purpose that may be difficult to meet in certain standard structures.

Which Holding Period is Relevant—the Holding Period in the API or in the Assets?

The Proposed Regs confirm that the applicable holding period for purposes of Section 1061 is the holding period of the asset being sold. Thus, if a partnership disposes of an asset, ‎it is the partnership’s holding period in the asset that controls for purposes of Section 1061, rather than the holding period of a partner in its API. A taxpayer’s holding period in its API is generally only relevant if the API itself is sold directly (subject to the lookthrough rules discussed below). Divided holding periods are typically ‎determined by using a fraction based on fair market values of the divided interests. The ‎Proposed Regs expand on this concept to provide that if a partnership interest is comprised in ‎whole or in part of one or more profits interests (i.e., a partnership interest, including an API, ‎other than a capital interest), then the portion of the holding period to which a profits interest ‎relates is determined based on the relative fair market value of the profits interest at the time of ‎the disposition of all or part of the interest (and not at the time the profits interest was acquired). ‎

Who and What Amount is Subject to Section 1061 Recharacterization?

‎Section 1061 uses but does not define the term “taxpayer,” causing some uncertainty as to ‎how its provisions should apply to partners who hold interests in passthrough entities ‎which themselves hold an API. The Proposed Regs clarify that for such purposes the term “taxpayer” includes both a ‎person subject to tax on the net gain with respect ‎to an API (referred to as an “Owner Taxpayer”) and ‎passthrough ‎entities that hold an interest in an API‎ (referred to as a “Passthrough Taxpayer”). Owner Taxpayers generally include individuals, simple and ‎complex trusts, and estates. Passthrough Taxpayers may include (i) the entity service provider, (ii) a ‎person related to the service provider, ‎‎(iii) entities engaged in an ATB, or (iv) the recipient of an interest ‎in connection with the performance of ‎substantial services in an ATB. If a Passthrough Taxpayer is ‎treated as the recipient (or holder) of ‎a partnership interest, directly or indirectly, for purposes of ‎determining the existence of an API, ‎the ultimate owners of the Passthrough Taxpayer, subject to certain ‎exceptions, are treated as Owner Taxpayers. ‎ ‎While both ‎Owner Taxpayers and Passthrough Taxpayers are used to determine whether a partnership interest is an API, the Proposed Regs, through a series of complex formulas, generally calculate at the Owner Taxpayer level only the amount of income associated with an API that its holder must treat as short-term ‎capital gain under Section 1061’s provisions (the ‎‎“Recharacterization Amount”).  Some highlights of these ‎complicated calculation rules include:‎

  • Since the Recharacterization Amount is calculated at the Owner Taxpayer level, such calculation can aggregate the ‎Recharacterization Amount for an owner in tiered partnership structures.‎

  • Although the Recharacterization Amount is calculated at the Owner Taxpayer level, the holding period of an asset giving rise to gain for purposes of Section 1061 is the ‎holding period of the direct owner of the relevant asset.‎

  • The Recharacterization Amount effectively equals the difference between the amount of capital ‎gains that would satisfy the one-year holding period requirement and the amount of capital ‎gains that would satisfy the three-year gain amount for APIs held by such partner, ‎separately calculating the taxpayer’s distributive share of capital gains from APIs and ‎capital gains from various dispositions with respect to an API to which Section 1061 applies‎.

  • A transition rule is provided with respect to interests acquired prior to the enactment of Section ‎‎1061 allowing partnerships that were in existence on January 1, 2018 to irrevocably elect to ‎exclude all long-term capital gains and losses from the disposition of all assets held by the ‎partnership for more than three years as of January 1, 2018 from the scope of Section 1061, ‎subject to a cap.‎ The preamble to the Proposed Regs explains that this rule is intended to alleviate documentation burdens for partnerships that may not have information readily available to enable them to otherwise determine the amount of one year and three year capital gains as of the effective date of Section 1061.

Transactions Covered by Section 1061 – Transfers, Lookthrough Rules, and Dispositions

The Proposed Regs capture a wide array of transactions potentially triggering Section 1061 recharacterization, which include both taxable dispositions and in-kind distribution transactions of partnership assets and both direct sales of APIs and indirect sales involving tiered passthrough structures, clarifying questions on the scope of Section 1061 remaining after its enactment.

Lookthrough Rules. One of the more important aspects of the Proposed Regs relates to certain look-through rules that can apply when the holder of an API with a holding period greater than three years disposes of the API in either a direct or indirect (i.e., when the API is held through one or more passthrough entities) sale (if 80% or more of the assets (based on value) of a passthrough entity in the API structure ‎consist of or are attributable to capital assets with a holding period of three years or less).‎ If applicable, the lookthrough rules can cause all or a portion of the gain from such sale to be subject to Section 1061 recharacterization, by adjusting the gain from such API sale to account for the value of long-term capital gain assets with a three year or less holding period within the API structure. In an indirect sale where the API is held by a lower-tier passthrough entity with less than a three-year holding period in the API, the adjustment generally equals the gain attributable the API.

Distributions. As a general matter, in-kind property distributions with respect to an API do not accelerate gain under the Proposed Regs, but the distributed property retains its potential for API taint in the hands of the API holder, thus foreclosing a potential planning opportunity that existed prior to the Proposed Regs. On a disposition of the distributed asset by the distributee-partner, recharacterization potential results if the distributee-partner has a holding period in such asset that is more than one year but not more than three years at the time of disposition. For this purpose, the character of the distributed property generally retains its character as it passes through tiers of passthrough entities. In addition, as noted below, there is a question over the interaction of these in-kind distributions rules ‎and the exclusions for income from certain properties, such as Section 1231 property (generally real or depreciable business property held for more than one year). ‎

Other Notable Exclusions or Exceptions relating to Dispositions

  • Specified Excluded Capital Gain. The Proposed Regs ‎confirm that items that are treated as capital gain without regard to the holding period ‎requirements of Sections 1222(3) and (4) are excluded from Section 1061. This includes so-called Section ‎‎1231 gains, qualified dividend income, Section 1256 marked-to-market capital gain, and capital ‎gains and losses characterized under the mixed straddle period rules of Section 1092(b). These exclusions are not necessarily comprehensive. For example, while the Proposed Regs exclude Section 1231 gains from Section 1061, a distribution of Section 1231 property that has been held for less than three years may still nonetheless be subject to the general Section 1061 distribution rules noted above. Further, transfers of an API to a related person (discussed below) may trigger taxation on gain ‎that would otherwise be excluded from Section 1061‎. The exclusion of Section 1231 gains is significant for real-estate-focused and energy-focused funds, though such funds and their owners should exercise caution with respect to in-kind distributions of and certain related party transfers involving Section 1231 property with a holding period of less than three years as such transactions may still be subject to Section 1061 (the Proposed Regs are not clear on this point).

  • Non-Third Party Investor Gain. Section 1061(b) gives the Treasury the authority to issue ‎regulations excluding from Section 1061 any income or gain attributable to any asset not held for ‎portfolio investment on behalf of third party investors. The Proposed Regs reserved on this matter, though the Treasury indicated in the preamble to the Proposed Regs that this exception is intended to ‎apply to family offices. ‎


Section 1061(d) generally accelerates the recognition of capital gain to a taxpayer who, directly, or indirectly, “transfers”2 an API to a “related person.”3 Such taxpayer will recognize short-term capital gain equal to the excess of (i) the net built-in long-term capital gain from assets held for three years or less that would have been allocated to the taxpayer had the partnership sold all of its assets over (ii) the amount treated as short-term capital gain under Section 1061(a). The Proposed Regs would require gain to be recognized even if the transaction would not otherwise be taxable. The examples in the Proposed Regs also make it clear that it does not matter how long the API has been held by the taxpayer. This acceleration feature of the Proposed Regs is likely to be controversial and possibly challenged in court ‎as the text of Section 1061 does not clearly support acceleration of gain recognition, and if retained will likely adversely impact estate planning and other wealth transfer planning techniques.

An interest in a partnership ‎that would be treated as an API but is purchased by an unrelated buyer for fair ‎market value is not an API with respect to the buyer if (i) the buyer does ‎not currently and has never provided services in the relevant ATB (or to a passthrough entity in which the interest is held, if different), (ii) does not contemplate ‎providing services in the future, and (iii) is not related to a person who provides ‎services currently or has provided services in the past. This exception does not apply to an unrelated non-service provider who becomes ‎a partner by making a contribution to a passthrough entity that holds an API and in ‎exchange receives an interest in the passthrough entity’s API.

Carried Interest Waivers

A potential work-around for Section 1061’s three-year holding period utilized by fund sponsors is the so-called ‎‎“carried interest waiver,” which permits an API holder to waive or defer capital gains from investments that have not yet satisfied the holding period and allow for later make-up ‎allocations to such holder. As a result, gains that would have been taxable at the higher tax rate for ‎short-term capital gains for a holder of an API are allocated to investors who are not subject to ‎Section 1061, but the API holder ultimately receives the same amount through the catch-up provisions. Although carried interest waivers are not directly addressed by the Proposed Regs, the Treasury noted in the preamble to the Proposed Regs that such arrangements may be subject to challenge under existing law, including ‎the substance over form and economic substance doctrines. As such, investors should take ‎particular care in structuring carried interest waivers to comply with existing law.‎

Planning Opportunities

There are a number of strategies and structures that taxpayers may try to implement and/or avoid in order to minimize the amount of income or gain that is subject to recharaterization under Section 1061. Since the Proposed Regs are not final, taxpayers should exercise caution before implementing any planning strategy as the final regulations could significantly alter the viability of such strategy. Some structures that taxpayers may want to consider are as follows:

  1. Qualified Dividends. Exit planning for a partnership which directly or indirectly owns one or more corporations should consider the possibility of leveraged dividend transactions as a first step to monetizing value, capitalizing on the exclusion of qualified dividend income from Section 1061.

  2. Acquisition Structuring. Taxpayers should consider structuring acquisitions in a manner so as to maximize carryover holding periods of target assets/entities.

Effective Date of the Proposed Regs

The Proposed Regs will generally apply to taxable years beginning on or after the date published as final regulations. Taxpayers may, however, rely on the Proposed Regs before such date provided they follow the Proposed Regs in their entirety and in a consistent manner (thus eliminating the ability to “cherry pick” select provisions of the Proposed Regs). Notwithstanding the foregoing, (i)‎ taxpayers may elect to rely upon the transition rules for 2020 and later years prior to ‎the date final regulations are published without regard to this anti-cherry picking rule and (ii) certain provisions carving out S corporations from a provision exempting corporations from the application of the Section 1061 recharacterization provisions apply to taxable years beginning after 2017.

We will continue to ‎closely monitor this issue and will provide future client updates on certain aspects of the Proposed Regs and once the final regulations are published. ‎For additional information and context, please contact one of the authors.


1.All “Section” references herein are to the ‎Code.
2. The Proposed Regs define a “transfer” broadly to include, but not limited to, contributions, distributions, ‎sales and exchanges, and gifts and clarify that a contribution to a partnership under Section 721(a) is not ‎treated as a transfer. Notably, the Proposed Regs do not address whether a “transfer” includes a transfer ‎upon death or a forfeiture of an API (for example, upon separation from service prior to vesting). ‎
3. The Proposed Regs define a “related person” for Section 1061(d) more narrowly than a related person ‎for purposes of the rest of Section 1061. It includes only (i) the taxpayer’s family (i.e., spouse, parents, ‎children and grandchildren), (ii) the taxpayer’s colleagues (those who provides services within the ‎current calendar year or the preceding three calendar years in any ATB in which the taxpayer performed ‎a service), and (iii) any passthrough entity if a member of the taxpayer’s family or colleague is an owner. ‎