With a looming presidential election and potential risk around what may happen to the existing lifetime gifting exemption, tax advisors have been hard at work discussing with fund principals different wealth transfer planning strategies involving the use of carried interest in private investment partnerships, such as hedge funds, private equity and venture capital funds. Fortuitously, planners focusing in this area received some encouraging guidance from Treasury and the Internal Revenue Service on July 31, 2020, with the issuance of proposed regulations (proposed regs) under Internal Revenue Code Section 1061 on the treatment of carried interests, in the form of rules addressing transfers to grantor trusts, disregarded entities and partnership contributions.
Section 1061
Section 1061, enacted as part of the Tax Cuts and Jobs Act of 2017, has the effect of recharacterizing certain net long-term capital gains with respect to applicable partnership interests as short-term capital gains. In general, it imposes a 3-year holding period to qualify for preferential long-term capital gains treatment on carried interest received by general partners of private equity (PE) funds and other alternative asset management funds (for example, hedge, energy, infrastructure, real estate, credit and fund of funds). This provision recharacterizes certain gain generated from the sale of investments held for one year or more (but less than three years) that would otherwise qualify as long-term capital gains, as short-term capital gains, taxed at higher, ordinary income rates.
The proposed regs provide some welcome news with respect to transfers of applicable partnership interests (APIs) in the context of typical wealth transfer transactions. While some further clarification and examples would be welcome, and comments on the proposed regs have been requested, these provisions appear to be moving in the right direction. 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” (ATB) for the partnership. Section 1061(c)(2), in turn, defines an ATB as any activity conducted on a regular, continuous, and substantial basis, through one or more entities that consists of, in whole or in part, (1) raising or returning capital and (2) investing in or disposing of “specified assets,” identifying such assets for investment or disposition, or developing such assets. Section 1061(c)(3) defines “specified asset” as 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.
IRC Section 1061(d) causes an acceleration of the recognition of capital gains in connection with the direct or indirect transfer of an API to a “related party” and recharacterizes certain long-term capital gains and short-term capital gains. For these purposes, the proposed regs indicate that a “transfer” includes contributions, distributions, sales and exchanges and gifts; however, a related person for purposes of Section 1061(d)(2) has a different definition than related person for purposes of Section 1061(c)(1) and includes only members of the taxpayer’s family within the meaning of Section 318(a)(1).
In addition, Section 1061(d) provides a rule for transfers of APIs to certain related persons. However, a special narrow definition of “related person” is provided under Section 1061(d)(2), which applies solely to transfers subject to Section 1061(d). Under the so-called “API Operational Rules” with respect to disregarded entities, it’s provided that entities that are disregarded from their owners (referred to as “disregarded entities”) under any provision of the IRC or regulations, which specifically include grantor trusts and qualified subchapter S subsidiaries, “are disregarded for purposes of [the] Regulations.” Thus, the summary to the proposed regs provides that “if an API is held by or transferred to a disregarded entity, the API is treated as held by or transferred to the disregarded entity’s owner.” To this end, Proposed Regulation Section 1.1061-2(a)(1)(v), entitled “Grantor trusts and entities disregarded as separate from their owners,” provides, “a trust wholly described in subpart E, part I, subchapter J, chapter 1 of the Code (that is, a grantor trust), a qualified subchapter S subsidiary described in section 1361(b)(3), and an entity with a single owner that is treated as disregarded as an entity separate from its owner under any provision of the Code or any part of 26 CFR (including §301.7701-3 of this chapter) are disregarded for purposes of §§1.1061-1 through 1.1061-6.” While various examples are included in Section 1.1061-2(a)(2), it doesn’t appear that any examples are provided with respect to transfers to grantor trusts. Hopefully, with the finalization of the regulations, such clarification can be obtained, both with respect to a transfer to a grantor trust by way of gift and with sale transactions.
The proposed regs seem to provide for favorable interpretation of transactions that are often implemented with respect to estate planning with carried interests. The proposed regs don’t, however, appear to address what happens on the affirmative “turning off” of grantor trust status after a transfer of an API to a grantor trust, whether by gift or sale, or whether any distinction should be made when the triggering event is the death of the grantor versus an affirmative “turning off” of such status during the grantor’s lifetime.
The proposed regs also provide that a contribution under Section 721(a) to a partnership isn’t treated as a transfer to a Section 1061(d) “related person.” This is because all unrealized gains attributable to the contributed API must be allocated to the holder of such contributed interest when those gains are recognized by the partnership under Section 704(c) and Treasury Regulations Sections 1.704-1(b)(2)(iv)(f) and 1.704-3(a)(9).
The proposed regs also make amendments to preexisting property holding period regulations to clarify how to bifurcate a partnership interest that consists of capital interest(s), API(s) or profits interests, issued at different times, and which require a divided holding period. There’s also guidance that may be relevant for holding periods related to add-on investments in portfolio companies structured as partnerships.
Gifts of Highly Appreciated Property
From a charitable perspective, one key item included in the proposed regs impacts those who commonly gift highly appreciated property with very low basis. The proposed regs would subject dispositions of property distributed to an API holder to IRC Section 1061 recharacterization. What this means is that where in the past, it was a common strategy to donate appreciated property distributed from a partnership to a charity, this strategy would now require the asset to achieve a 3-year holding period or otherwise have the deduction limited to its tax basis.