Carried interests and Section 1061
Carried interests in partnerships earn income that is harder to report as long-term capital gain.
The classic carried interest is one that entitles the holder to a share of the upside after an investor has reached a return threshold.
Section 1061 of the US tax code, enacted in late 2017, targeted individual investment fund managers whose income for managing funds is paid to them in their capacities as partners in the funds. Asset sales by the fund may produce long-term capital gains that are taxed at reduced rates if the assets have been held for more than a year. The character of the income as long-term capital gain normally passes through to the partners.
Critics charge that the income received in this manner by fund managers is essentially compensation that should be taxed at ordinary rates.
The bare language of section 1061 does not appear to cover the types of carried interests that project developers in the project finance market receive when a money partner is brought into a partnership to own a project.
The IRS confirmed this in 162 pages of proposed regulations that it issued in July to implement the new section.
The IRS said the section applies to partnerships that own the following types of “specified assets”: securities, commodities, real estate held for rental or investment, cash, cash equivalents, options and derivatives contracts with respect to any of the foregoing, and interests in other partnerships that hold these types of assets.
In addition, the person receiving the carried interest must receive it in exchange for certain services that either it or an affiliate will provide to the partnership. The services are “raising or returning capital” or investing in or developing these types of specified assets. A person is considered to be “developing” specified assets if the fund represents to investors, lenders, regulators or other interested parties that the value, price or yield may be enhanced or increased because of the choices or actions of the partner receiving the carried interest.
If that is not enough, the section does not apply to carried interests received by corporations (but not S corporations, which remain covered).
If the partner holding the carried interest has both a “profits” interest and a “capital” interest, the section does not apply to gains to the extent they are attributable to the capital interest. Most partnership interests are both profits and capital interests. A profits interest entitles the partner to a share of ongoing partnership income. A capital interest entitles the partner to a share of the partnership assets when the partnership liquidates.
The carried interest is no longer covered by section 1061 after it is sold to a third party who has never provided services to the partnership itself or through an affiliate and does not plan to do so in the future.
If section 1061 applies, then two things happen.
First, the partnership must have held assets for more than three years before the share of gain on sale reported by the carried interest holder qualifies as long-term capital gain.
Second, any transfer of the carried interest to an affiliate triggers immediate tax to the carried interest holder on the unrealized gain in the partnership assets that have been held for three years or less. However, the carried interest can be transferred to a partnership with one or more affiliates without triggering tax.