It should also be noted that an effective regulatory regime for section 1061(b) would need to include a workable framework for determining the “relatedness” of service providers in the family office context, properly taking into account different related lines of lineage and marriage, including sequential marriages.
Accordingly, it is advisable for family offices and their advisors to closely monitor developments relating to the family office exception, because it may have significant implications for family structures where some or all of the API holders are family members.
Exception for Capital Interests
The three-year holding period rule does not apply to a partnership interest (or portion thereof) with respect to which allocations of capital gain or loss are made based on the relative capital accounts of the partners. To qualify, the holder’s allocations with respect to its contributed capital must broadly match the allocations of other non-service partners who represent a “significant” portion of the partnership’s aggregate capital account balance (at least 5%). The Proposed Regulations indicated that an allocation would not fail to qualify solely because it is subordinated to allocations made to unrelated non-service partners or it is not reduced by the cost of services provided to the partnership by the API holder or a related person (e.g., management fees). The Final Regulations eliminated the requirement that allocations to API holders must be based on relative capital account balances, and relaxed other aspects of the capital interest exception; this has made the exception more broadly available to funds that do not make allocations in accordance with capital account balances.
Capital interests funded by a loan from another partner in the partnership (or related person to that partner, other than the partnership, itself) may qualify for the Capital Interest Exception, provided the borrower remains personally liable for the loan. The debt permission is important because, many times, individual managers do not have ready access to the magnitude of capital necessary to invest at the desired level, and in a closely-held business, it is not uncommon for these investments to be made on credit. (In addition, many funds offer loans to employees to purchase equity as a matter of course.) This rule prevents an IRS argument that because an investment was funded with debt it should not be respected as an investment until the principal is repaid. Capital interest allocations must be clearly identified both under the partnership agreement and on the partnership’s books and records as separate and apart from allocations made to an API Holder with respect to its API, raising the possibility that some partnership agreements may need to be amended in order to support qualification for this exception.
Overall, the capital interest exception is beneficial to family members who are invested in the partnership and who also manage the partnership investments on a part- or full-time basis. But, of course, it does not address the gap noted above in the discussion of the family office exception.
Carried Interests Issued to Certain Corporations
Under the statute, APIs held directly or indirectly by corporations are not subject to the three-year holding period regime. Consistent with prior guidance, the Proposed Regulations provided, and the Final Regulations reiterate, that an S corporation is not considered a corporation for purposes of this exception, which is not surprising given the flow-through nature of S corporations.
Corporations are less commonly used for management vehicles in the purely domestic private placement industry, but are more common in the private family setting. Corporations might be organized to serve as a family office or private trust company and might participate in underlying family investment partnerships, earning a carried interest for services performed. In those cases, the business activity and incentives provided make the C Corporation option compelling. Additionally, there may be less relative sensitivity to the two levels of tax resulting between a C corporation and dividends distributed to its shareholder(s). For families with Corporation family offices or private trust companies, carried interest planning is highly relevant and might have great value, but the limitations imposed by these new regulations, relating to S corporations should be taken into account as applicable.
The regulations also bar from the “corporate holder” exception for APIs owned by any “passive foreign investment company” or “PFIC” for which a “QEF election” has been made (a PFIC with a QEF election in place functionally is a C corporation that is taxed in a manner similar to a flow-through vehicle).
Certain Investments in Real Estate and Financial Instruments
The Proposed Regulations took the position, and the Final Regulations confirmed, that certain types of income that are treated as LTCGs or qualify for preferential LTCG rates, regardless of holding period, are unaffected by the three-year holding period rule. Importantly, this includes the gain on certain depreciable real and personal property used in a trade or business that is treated as long-term capital gain under Section 1231 of the Code. This means that capital gains generated by family office real estate investments, which are often held through tiered partnership structures, may continue to qualify for LTCG treatment regardless of holding period.
Other types of income not subject to recharacterization under the three-year rule include qualified dividend income (i.e., dividends paid by domestic C corporations and certain foreign corporations that satisfy applicable treaty qualification requirements) and certain regulated futures contracts, foreign currency contracts, and non-equity options that are annually marked-to-market, with gains treated as partly LTCG and partly STCG. Capital gain dividends paid by REITs and RICs may also qualify, depending on the source of the dividend, and subject to the satisfaction of certain reporting requirements by the distributing REIT or RIC.
Considerations Where the Three-Year Holding Period Rules Apply
Holding Period Determinations
For purposes of making holding period determinations under the three-year holding period rule, the relevant holding period generally is the holding period of the asset that is sold or exchanged. For instance, if a fund sells stock of a portfolio company, the relevant holding period is the fund’s holding period in the portfolio company stock (as opposed to the holding period of the carry vehicle in its carried interest in the fund, or an individual carry partner’s holding period in the carry vehicle). By contrast, if a partner recognizes gain from the sale or exchange of an API (whether actual or deemed), subject to the look-through rule discussed below, the relevant holding period is generally the partner’s holding period in the API.
The Proposed Regulations included a limited look-through rule (Lookthrough Rule) that, where applicable, would have had the effect of overriding the general holding period rules discussed above where 80% or more of the fair market value of the relevant partnership’s assets were assets that would produce STCG or STCL if disposed of by the partnership. Under the Final Regulations, the Lookthrough Rule was significantly scaled back and replaced with an anti-abuse rule that applies where, at the time of a 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 the API were determined by excluding any period before which third-party investors have capital commitments to the partnership, or (2) a transaction or series of related transactions has taken place with a principal purpose of avoiding potential gain recharacterization under section 1061(a).
Family Planning and Related Party Transfers
The Final Regulations also removed a provision in the Proposed Regulations that treated the transfer of an API to a related person in an otherwise non-taxable transaction as an acceleration event under section 1061(d). The statute provides that transfers of APIs to related parties are treated as taxable transfers to which the three-year holding period may apply. The Proposed Regulations interpreted this to include nontaxable transfers (such as gifts), posing a challenge to common intra-family transfers. Specifically, the Proposed Regulations indicated that, once a partnership interest qualifies as an API, it generally remains an API regardless of subsequent transfers, gifts or other dispositions, unless and until an exception becomes applicable. In the Final Regulations, however, Treasury determined that it is more appropriate to apply the statutory provision only to transfers in which gain is otherwise recognized.
Management “Waivers” of a Carried Interest Rights Will Be Scrutinized
The preamble to the Proposed Regulations indicated that Treasury and the IRS are aware that API holders may seek to circumvent the three-year holding period rules by waiving rights to gains on the disposition of property held for three years or less and substituting rights to receive proceeds from gains generated from the disposition of capital assets held for more than three years. Treasury warned that taxpayers should be aware that such waivers may be challenged under various principles of Subchapter K and judicial doctrines.
Reporting Requirements, As Always, Need to be Addressed
The regulations require API holders to report specific information to evidence their compliance with the three-year holding period rules, and require partnerships that have issued APIs to provide information to their partners through Schedules K-1 sufficient to facilitate those reporting requirements and permit API holders to determine their LTCGs and STCGs under the three-year holding period rules.