The Treasury Department and the IRS recently issued final rules for the treatment of “Interest Income” under Section 1061 of the Taxes Act.
Section 1061, added under the Tax Reductions and Employment Act (TCJA) of 2017, increases the required holding period to more than three years (compared to the normal rule of more than one year) to allow fund managers to benefit from the lower tax long-term capital gains rates for the allocation of interest income.
In a first round of the regulation proposals published in July 2020, some, but not all long-standing questions about the application of the law were clarified. Many commentators felt that the proposed regulations were inconsistent with industry practice and were too complex.
The final regulations generally adopt the proposed regulations; However, the Treasury Department and the IRS have made significant tax-friendly changes in the areas described below.
Interest rate exception
According to Section 1061, equity investments are exempt from being changed if they represent a return on the capital invested in a partnership. The proposed regulations contained a very narrow interpretation of this exemption as they required (a) that the allocations in the partnership agreement be based on the relative capital accounts of the partners receiving the allocations, and (b) that the conditions, priority, art and the level of risk, return, and rights to cash or property distributions during the partnership’s business and liquidation are the same as for non-service partnerships. Many commentators feared that hedge fund, venture capital, and private equity fund managers would not be able to take advantage of the interest rate exemption, as many funds do not allocate based on capital accounts under section 704 (b), but rather allocate based on targeted allocations or other methods.
The final regulations have scaled back these rules while retaining some factors in the proposed regulations and have been updated to the effect that “the capital interest allocation must correspond to the capitalization brought in [by unrelated non-service partners] to qualify for the exception. “The test can be applied on an investment-by-investment basis or based on assignments to a specific interest class. As a result of these changes, it is expected that joint economic arrangements in private equity and hedge funds will now qualify for the interest rate exemption if they would not have qualified based on the language in the proposed regulations.
API profit reinvestment
It is very common for hedge fund managers to reinvest transferred shares in the fund and there was no guidance as to whether the reinvested carry would be subject to Section 1061. The final terms provide that reinvestment of applicable Partnership Shares (API) profit (either as a result of an actual distribution and redistribution of the API profit amount or the partnership’s retention of API profit will be treated as an equity interest. An example in the Under final terms, the reinvestment of API realized gains will qualify as equity, however, it appears that API unrealized gains will continue to be subject to Section 1061 re-characterization.
The treatment of interest on capital acquired with loan proceeds
The proposed rules did not apply the interest rate exemption to a partner who borrows funds from the partnership, another partner, or an affiliate in order to make capital contributions. Several commentators said the rule “inhibits common and sound business practices and creates barriers to entry for service partners.” The Treasury Department and IRS took into account some of the comments but believed that loans could be used to abuse the interest on capital exemption. However, they believed that if the service provider is personally liable to repay the loan that was used to make a capital contribution, the potential for abuse is reduced. The final provisions therefore provide that the capital brought in by a service partner with funds borrowed will be treated as principal interest if the service partner is personally liable for the loan.
The Lookthrough rule for certain API dispositions
The proposed rules included a rule of passage for selling an API that was held for more than three years. The holding period of the assets in the partnership must also be checked to determine whether 80% of those assets have a holding period of three years or less. This requirement is known as the “essentially all” test. In a tiered partnership structure, the administrative burden of applying these rules to lower tiered partnerships was significant. The final regulations have simplified this rule by removing the “essentially all” test.
Broadcasting APIs to Relatives
The proposed rules provided that when transferring an API to a related party, the transferring partner could recognize short-term capital gains from a hypothetical sale of the underlying assets of the API. Such transfers included dues, distributions, sales and exchanges, and gifts. This was very controversial as it was an acceleration event on a transaction that would otherwise not be taxable.
The final terms state that if a transfer was otherwise not taxable, that transfer will not expedite tax recognition and the acquirer who owns the API will be subject to Section 1061. This is a welcome change. Giving interest income is a common estate planning technique that is now legal but would have been a trap for the unwary under the proposed rules.
Good faith buyer
In many cases, shares in a partnership are sold by outgoing managers with a transferred interest claim. In some cases, non-service partners receive part of the interest entitlement as an incentive to provide seed capital. The final terms provide that Section 1061 does not apply to the Shares acquired when a non-service partner acquires a partnership interest in an API. However, if instead of acquiring a partnership stake, a non-service partner is contributing capital to a partnership with an API, there is no similar exception. Accordingly, while the buyers are not providing services, they are subject to Section 1061. Seed investors should consider the implications of Section 1061 when structuring their acquisitions of companies using an API.
Distribution of items
For distributions of securities held for more than one year and less than three years to an API holder, the proposed regulations stipulate that the API must hold the securities distributed for more than three years, including the transferor’s holding period with one non-taxable transfer. to capture long term capital gains. The final provisions clarify that in the event of a distribution of securities that are not subject to Section 1061 (assets pursuant to Section 1231 or Section 1256), the sales partner’s three-year holding obligation does not apply.
Final thoughts
The government has significantly narrowed the scope and reduced the complexity of the rules on interest income, which is a welcome change. The final provisions give mutual funds much more flexibility to qualify for the interest rate exemption and allow fund managers to gift delegated interests to family members, which is a very common estate planning technique. Fund managers should be aware of these changes and review fund documents to ensure that their capital interests avoid re-characterizing profits in accordance with Section 1061.
While the final rules contain much-needed guidance on taxing savings income, the future of this legislation remains unclear. It appears that both houses of Congress were tightly controlled by Democrats at the beginning of the Biden administration. This majority can enable the Democratic Party to make significant changes to tax law. President-elect Biden could seek to completely eliminate the carryforward tax break, and his proposed tax plan would eliminate preferential capital gains rates for those earning more than $ 1 million a year, which would significantly reduce the carryforward tax break for fund managers.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Information about the author
Moshe Biderman, Jonathan R. Collett and Robert Richardt are CohnReznick’s tax partners, and Mark Papa is a senior tax manager. All are members of the company’s financial services industry.