On Jan. 7, 2021, the Internal Revenue Service released final regulations under Internal Revenue Code Section 1061 concerning the income taxation of carried interests in private investment funds (the final regs) (T.D. 9945). The final regs depart significantly from the proposed regulations (proposed regs) released on July 31, 2020 on issues near and dear to the estate-planning and family office community and clarify that gifts to related persons, including to non-grantor trusts, within IRC Section 1061’s prescribed 3-year window won’t constitute a triggering acceleration event to cause deemed short-term capital gains. The final regs also confirmed the proposed regs’ favorable treatment of transactions with grantor trusts as not being subject to Section 1061.
Section 1061
Enacted as part of the Tax Cuts and Jobs Act of 2017, Section 1061 will in certain instances recharacterize net long-term capital gains (LTCGs) with respect to “applicable partnership interests” (APIs) held for up to three years as short-term capital gains to be taxed at the higher, ordinary income tax rates. APIs include carried interests received by general partners of private equity funds and other alternative asset management funds (for example, hedge, energy, infrastructure, real estate, credit and fund of funds).
The language of Section 1061(d) raised concerns whether it may cause an acceleration of the recognition of capital gains in connection with the direct or indirect transfer of an API to a “related person” (as defined here specifically by reference to IRC Section 318(a)(1)) and, in this context, likewise recharacterize certain LTCGs as short-term capital gains.
The Proposed Regs
The proposed regs took the position that Section 1061(d) is an acceleration provision and expansively defined “transfers” to related persons that could trigger acceleration to include contributions, distributions, sales and exchanges and gifts.
Under the so-called “API Operational Rules,” the proposed regs 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 preamble’s summary of 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,” provided that “[a] trust wholly described in subpart E, part I, subchapter J, chapter 1 of the Internal Revenue 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 Internal Revenue Code or any part of 26 CFR (including § 301.7100-3 of this chapter) are disregarded for purposes of [the Section 1061 Regulations].” The final regs maintained this language. It therefore follows that the scope of this exclusion would embrace the full scope of transactions between a grantor and that grantor’s grantor trust that would be disregarded pursuant to Revenue Ruling 85-13 and related guidance.
ACTEC’s Comment Letter
In its comment letter dated Oct. 5, 2020, the American College of Trust and Estate Counsel (ACTEC) focused on the application of the proposed regulations to trusts and estates and family offices. ACTEC raised two primary issues, together with a series of “sub-issues.”
1. ACTEC suggested that, in light of Section 1061(d)’s specific reference to section 318(a)(1), the Treasury should confirm that a gift to a non-grantor trust for the benefit of a taxpayer’s spouse, children, grandchildren or parents shouldn’t be considered an "indirect transfer" that would trigger the application of section 1061(d). ACTEC moreover challenged the general notion that any sort of occurrence or transaction in the estate planning realm (such as death, or the conversion from grantor trust status to nongrantor trust status, or vice versa) should be considered a triggering event under Section 1061(d), and questioned whether the proposed regs’ recognition of a deemed gain in connection with a transfer to a related person that didn’t otherwise constitute a recognition event under other provisions of the IRC was consistent with Congress’ intent in enacting Section 1061(d) (the acceleration and transfer issue).
2. ACTEC asserted that the Section 1061(b) exclusion for partnerships without third party investors (which is often the case with family offices) isn’t properly implemented by the mechanisms set forth in the proposed regs and requested that further guidance be provided including to broaden the definition of related persons for purposes of the family office exclusion to include in-laws and their family members. ACTEC further suggested that the Treasury Department may wish to borrow from the broader definition of family that’s used in IRC Section 2704(c)(2) (the family office exclusion issue).
The Final Regs
The final regs under Section 1061 adopted many of ACTEC’s recommendations.
On the acceleration and transfer issue, the final regs eliminate the acceleration of gain provisions that were contained in the proposed regs and will now generally exclude gifts to related parties that are made during a 3-year window from being considered transfers that are subject to Section 1061, irrespective of whether such transfers are made outright or in trust. The final regs instead treat Section 1061(d) as solely a “recharacterization provision” and expressly provide that the amount to be recharacterized as short-term capital gains under Section 1061(d) (the Section 1061(d) Recharacterization Amount) includes only LTCGs from assets held for three years or less that the owner-taxpayer recognizes under chapter 1 of the Code on a transfer through a sale or exchange of an API to a Section 1061(d) related person. Very significantly, gone now from the definition of a “transfer” are the references to contributions, distributions and gifts that were contained in the proposed regs. That being said, presumably, Section 1061(d) would apply as well under the final regs to certain “deemed sales or exchanges” that may arise under other provisions of the IRC that don’t involve grantor trusts or other disregarded entities. Such could potentially include gifts to Section 1061(d) related persons when debt is in excess of basis, or trust decantings that don’t entail a continuation of grantor trust status from the distributing trust to the recipient trust.
The final regs also maintain the favorable treatment of grantor trusts that were contained in the proposed regs. Accordingly, transactions with grantor trusts (including sales and swaps) that aren’t subject to tax by virtue of Rev. Rul. 85-13 continue to be outside the scope of Section 1061(d).
On the family office exclusion issue, the Treasury Department eliminated certain definitions that the proposed regs had attempted to rely on for “double duty purposes” that ACTEC had taken issue with (such as the term “passthrough interest direct investment allocation”). In the preamble to the final regs, the Treasury Department noted that it continues to study the comments regarding Section 1061(b) and may address the application of that provision in future guidance, and requests additional comments related to Section 1061(b).
Subject to certain exceptions, the final regs generally apply to taxable years of taxpayers and pass-through entities beginning on or after the date of their publication in the Federal Register. In many instances, this will be for tax years beginning Jan. 1, 2022. A taxpayer or pass-through entity may, however, choose to apply the final regs in their entirety to a taxable year beginning after Dec.31, 2017, provided that it consistently applies the final regs in their entirety to that year and to all subsequent years.
Kevin Matz is a partner at the law firm of Stroock & Stroock & Lavan LLP in New York City.
