IRS Releases Final Regulations on Recharacterization of Carried Interest

Capital Interest Gains and Losses Exception

Allocations to Capital Interests. The Final Regulations provide that in order for a taxpayer to rely on the capital interest gains and losses exception to Section 1061 recharacterization, an allocation to a holder of an applicable partnership interest with respect to its capital interest must be determined and calculated in a similar manner (commensurate with capital contributed) as the allocations with respect to capital interests held by similarly situated “unrelated non-service partners” (i.e., third-party investors) who have made significant aggregate capital contributions, as clearly identified in the partnership agreement and the partnership’s books and records.  

Reinvested or Retained Capital. The Final Regulations also clarify that gains with respect to an API remain subject to Section 1061 until recognized, but gains attributable to reinvested or retained capital from taxed API gains may qualify for the capital interest gains and losses exception. 

Recourse Loans. The Final Regulations also provide that an interest may be a capital interest even if funded by a loan or advance from another partner in the partnership (or any related person other than the partnership) to such individual service provider provided that (i) the loan is fully recourse to the individual service provider, (ii) with respect to which the individual service provider has no right to reimbursement from any other person, and (iii) the loan is not guaranteed by any other person.  

Practice Note: Fund sponsors should review their applicable partnership agreements to ensure that such agreements meet the clear identification requirements under the capital interest gains and losses exception.

Gains on the Sale of APIs and Distributed API Property

Narrowed Look-Through Approach. With respect to determining the taxpayer’s holding period  on a taxable disposition of an API, the Final Regulations remove the Substantially All Test (80% Test) from the Proposed Regulations (see the Proposed Regulations Alert) and limit the “look-through” requirement to situations in which, 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 not including any period prior to the date that an unrelated nonservice partner is legally obligated to contribute substantial money or property directly or indirectly to the “passthrough entity” to which the API relates, or 

(2) a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under Section 1061(a).

Non-1061 Gain. The Final Regulations confirm that long-term capital gain from the disposition of  “distributed API property” that, if sold by the partnership, would not be recharacterized under section 1061(a), such as Section 1231 or Section 1256 gain, qualified dividends described in Section 1(h)(11)(B), and any other capital gain that is characterized as long-term or short-term without regard to the holding period rules in Section 1222.

Transfers to Related Parties

The Final Regulations confirm that Section 1061(d) does not accelerate gain with respect to all transfers to related parties and provide that the amount that may be recharacterized includes only long-term gain that the taxpayer recognizes upon a transfer through a taxable sale or exchange of an API to certain related parties.

Elimination of Transition Rule

The Final Regulations eliminate the ability of a partnership that was in existence as of January 1, 2018, to elect not to take into account all long-term capital gains and losses recognized from the disposition of all assets held by the partnership for more than three years as of January 1, 2018, for purposes of the recharacterization calculation, as it was deemed unnecessary given the operation of the Final Regulations.

Effective Date and Other Changes

The Final Regulations are generally effective on the date of their publication in the Federal Register.