January 26, 2021

Highlights From The Final Carried Interest Regulations

On January 7, 2021, the U.S. Treasury Department and the Internal Revenue Service released final regulations under Section 1061 of the Internal Revenue Code of 1986, as amended (“the Code”).[1] The Final Regulations address the three-year holding period requirement under Section 1061 in order for holders of certain “carried interests” to qualify for preferential capital gains tax rates. The extended holding period requirement was added to the Code in 2017 by H.R. 1, commonly referred to as the “Tax Cuts and Jobs Act.” The Final Regulations generally adopt the same approach taken by the proposed Treasury Regulations that were released on July 31, 2020 (the “Proposed Regulations”), but make certain significant helpful and taxpayer-favorable modifications to the Proposed Regulations, although some questions and difficulties still remain. Please refer to Goodwin’s previous memorandum regarding the Proposed Regulations.


Generally, Section 1061 requires a taxpayer holding an “applicable partnership interest” (an “API”) in a partnership to recalculate its share of long-term capital gains from sales of partnership capital assets, and its long-term capital gains from sales of APIs, by requiring a three-year holding period, rather than the general one-year period, to qualify for taxation at the reduced rates currently applicable to long-term capital gains.

Section 1061(c)(1) defines an API as any interest in a partnership transferred to, or held by, a taxpayer, directly or indirectly, in connection with the taxpayer (or any related person) performing substantial services in an “applicable trade or business” (an “ATB”) for the partnership. Section 1061(c)(2) defines an ATB to be any activity conducted on a regular, continuous and substantial basis, through one or more entities that consists of, in whole or in part, (i) raising or returning capital and (ii) either (A) investing in or disposing of “specified assets” (or identifying such assets for investment or disposition) or (B) developing such assets. Section 1061(c)(3) defines “specified assets” to mean securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivatives contracts with respect to any of the foregoing and an interest in a partnership to the extent of such partnership’s proportionate interest in any of the foregoing.

The Final Regulations generally retain the structure and form of the Proposed Regulations, while modifying certain provisions to be more taxpayer favorable, as applicable to common economic arrangements in the investment management industry and, in particular, private equity funds. The principal modifications to the Proposed Regulations are discussed below.

Summary Of Principal Rules Retained In The Final Regulations

The Final Regulations generally retain the following, mostly taxpayer favorable rules, proposed in the Proposed Regulations:

  • If a partnership disposes of an asset it has held for more than three years, the gain generally qualifies as more than three-year gain even if an API holder does not have a more than three-year holding period in its API (subject to the look-through rule described below).
  • “Qualified dividend income,” long-term capital gains from property used in a trade or business (including many real estate assets) and mark-to-market capital gains are not subject to the three-year holding period requirements for APIs.
  • The preamble to the Proposed Regulations suggested that, although potentially subject to challenge, carried interest waiver arrangements would be respected if properly structured. The Final Regulations are silent with respect to such waivers, implying that no change in approach from the Proposed Regulations was intended.
  • Partnerships that invest through REITs can apply Section 1061 by “looking through” the REIT and thereby avoid the application of Section 1061 for most real property gains earned through a REIT.
  • Although gain from an asset distributed in-kind to an API holder remains subject to the three-year holding period requirement, the holder can generally retain the partnership’s holding period in the distributed asset.
  • Carried interest held through a corporation is not treated as an API unless the corporation is an S corporation or a PFIC with respect to which a QEF election has been made; notably, carried interest held through a REIT is excluded from API treatment.
  • The preamble to the Final Regulations confirms that an interest in a partnership that was an API in the hands of the seller of such interest will not be treated as an API in the hands of the buyer of such interest if the interest is acquired by a bona fide purchaser who (i) does not provide services in the partnership’s business to which the acquired API relates, (ii) is unrelated to any service provider of the partnership and (iii) acquired the interest for fair market value.
  • Upon the disposition of a partnership interest comprised, in whole or in part, of one or more profits interests, the portion of the holding period to which each such profits interest relates is determined based on its relative fair market value at the time of disposition (and not acquisition) of all, or part, of each such profits interest.

Principal Changes To The Proposed Regulations In The Final Regulations

  • Exception for Capital Interests. Section 1061(c)(4)(B) provides that an API generally does not include a capital interest in a partnership that provides a right to share in partnership capital commensurate with the amount of capital contributed (the “Capital Interest Exception”). The Capital Interest Exception is needed so that the scope of Section 1061 remains consistent with the underlying policy of taxing carried interests, but not other partnership interests, at higher rates comparable to the ordinary income rates generally applicable to other forms of compensation. The Proposed Regulations had adopted surprisingly restrictive and rigid requirements for the Capital Interest Exception and perhaps unworkable in many private investment funds.

    The Final Regulations adopt a less stringent and less rigid set of rules by providing that allocations in respect of a capital interest will satisfy the Capital Interest Exception if such allocations are “determined and calculated in a similar manner” as capital interest allocations to unrelated non-service providers that have made “significant aggregate capital contributions” (i.e., representing at least 5% of a partnership capital). Such test may be applied on either an “investment-by-investment” basis or “class-by-class” basis. The partnership agreement and the partnership’s books and records must “clearly demonstrate” that allocations are made in a “similar manner” to such non-service provider partners.

    The Final Regulations employ a list of factors for determining whether allocations meet the “similar manner” requirement. These factors include, but are not limited to, (i) the amount and timing of capital contributed, (ii) the rate of return on capital contributed, (iii) the terms, priority, type and level of risk associated with capital contributed and (iv) the rights to cash or property distributions during the partnership’s operations and on liquidation. The Final Regulations also specify that an allocation with respect to a tested partnership interest will not cause such interest to fail the “similar manner” requirement solely because either (i) the allocation is subordinated to other allocations made to unrelated non-service providers, (ii) an allocation is not reduced by the cost of services provided by the holder of such interest (or certain related persons) to the partnership (e.g., a management fee) or (iii) the holder of such interest has a right to receive tax distributions while unrelated non-service providers do not, where such tax distributions are treated as advances against future distributions.

    We anticipate that the Capital Interest Exception will line up well with commercial practice, including with respect to distribution-driven agreements.
  • Loans and Advances Used to Fund Capital Interests. Generally, the Proposed Regulations excluded a partnership interest from the Capital Interest Exception, which would otherwise qualify, if such partnership interest was funded by any loan (or other advance) made or guaranteed by any other partner, the partnership or certain of their related persons. The Final Regulations modify this rule to provide that as long as an individual service provider is “personally liable,” such loan funding will not preclude a partnership interest from qualifying for the Capital Interest Exception. For purposes of these rules an individual service provider is “personally liable” if (i) the loan or advance is fully recourse to such individual service provider, (ii) the individual service provider has no right to reimbursement from any other service provider and (iii) the loan or advance is not guaranteed by any other person.
  • Holding Period Look-Through Rules. The Proposed Regulations included a “look-through” rule that would have required the transferor of an interest in an API with a holding period of more than three years to look-through to the underlying assets of partnership if 80% or more of the assets of the partnership were held for three years or less, excluding assets that, if sold, would not generate gains otherwise subject to recharacterization under Section 1061 (e.g., Section 1231 gains).

    The Final Regulations significantly modify this rule. Under the Final Regulations, the look-through rule applies only to the extent that an API with a greater than three year holding period is disposed of, and either (i) the holding period of the API would be three years or less if the holding period of such API were determined by not including any period before the date that an unrelated non-service provider was legally obligated to contribute substantial money or property directly or indirectly to the partnership (with substantial being at least 5% of the total capital contributions to the partnership as of the time of the disposition) or (ii) a “principal purpose” of the a transaction or series of transactions has taken place with a principal purpose of avoiding Section 1061. Although the look-through rule may have been intended as a limited anti-abuse rule, the first prong (excluding periods before the first non-service provider contributions) could apply to many non-abusive situations. When it applies, the look-through rule in the Final Regulations does not exclude assets that, if sold, would not generate gains subject to recharacterization under Section 1061 (e.g., the rule can apply even if the underlying assets are limited to those that generate Section 1231 gains).
  • Transfers to Related Parties. Section 1061(d) provides that if a taxpayer transfers an API, directly or indirectly, to certain persons related to the taxpayer (e.g., certain family members and colleagues who provided services in the partnership’s ATB and pass-through entities that have such owners), the taxpayer must include in gross income, as short-term capital gain, so much of the taxpayer’s long term capital gains, with respect to such API, attributable to any asset held by the partnership for not more than three years and allocable to such API. The Proposed Regulations generally required the accelerated recognition (rather than mere recharacterization) of short-term capital gains in connection with any such transfer, regardless of whether gain was realized or recognized under the Code in connection with such transfer. The Final Regulations modify the rule under Section 1061(d) to treat it solely as a recharacterization (rather than an acceleration) provision, such that Section 1061(d) will only apply to taxable transfers in which long-term capital gain would otherwise be recognized under the Code. This change permits holders of APIs to engage in common practices associated with estate planning, such as making gifts of APIs or interests in APIs to family members.

Effective Dates

The Final Regulations are generally applicable to the taxable years of a taxpayer that is the holder of an API beginning on or after January 19, 2021. Taxpayers may choose to apply the Final Regulations to a taxable year beginning after December 31, 2017, as long as they are applied consistently and in their entirety. 

[1] All Section references are to the Code.