On January 7, 2021, the Internal Revenue Service (the IRS) and the U.S. Department of the Treasury ("Treasury") issued final regulations (T.D. 9945) addressing circumstances under which net long-term gains will be recharacterized as short-term capital gains with respect to certain partnership interests (the "Final Regulations"). The Final Regulations provide guidance under Section 1061 of the Internal Revenue Code (the "Code")1 and finalize certain provisions of the proposed regulations (REG-107213-18) issued on July 31, 2020 (the "Proposed Regulations"), as summarized in our previous client publication, "IRS Proposes Carried Interest Rules Recharacterizing Certain Capital Gain in Connection with Profits Interests."

In response to comments, Treasury has modified the Proposed Regulations to more appropriately take into account commercial realities and thereby better implement Congress's intent that Section 1061 apply only in limited circumstances. However, the Final Regulations leave important questions unanswered, and some provisions remain vague, with the result that the scope of Section 1061 is still uncertain in some respects.

The following summarizes certain key differences between the Final Regulations and the Proposed Regulations.


Section 1061, which was added to the Code by the Tax Cuts and Jobs Act, serves to limit the opportunities for carried interests to be taxed as long-term capital gain by generally requiring a three-year holding period, instead of a one-year holding period, for gains to be characterized as long-term capital gain in the case of gains allocated (or otherwise recognized) with respect to an applicable partnership interest (API). Generally speaking, subject to exceptions, an API is a partnership interest held by a taxpayer (directly or indirectly) in connection with the direct or indirect performance of services by the taxpayer or a related person in an "applicable trade or business," which generally is a trade or business that involves raising or returning capital and investing in (or disposing of), or developing, certain types of investment assets. The three-year holding period requirement applies only to gains that are characterized as either long-term or short-term under Section 1222, such that Section 1061 does not recharacterize long-term capital gain determined under Sections 1231 and 1256, qualified dividend income taxed as long-term capital gain, and any other capital gain characterized as long-term without regard to the holding period rules in Section 1222 (such as capital gain characterized under the identified mixed straddle rules).

A simple example of an API would be an interest in a carry vehicle awarded to an individual in exchange for investment management services regularly performed by the individual for the benefit of the underlying partnership, where the carry vehicle is a partnership or other passthrough entity.

Some partnership interests that do not involve any rights resembling carried interest are still APIs. For example, consider a real estate joint venture structured as follows. The joint venture is a limited liability company classified as a partnership for tax purposes. Party A, the managing member, is, pursuant to the joint venture's operating agreement, responsible for providing management services to the joint venture (or to its subsidiaries). Party A sourced the joint venture's investment opportunity and then negotiated with Party B the joint venture's economic terms; both parties contribute the same amount of capital to the joint venture, but assume Party A is entitled to a greater share of distributions with respect to its equity interest. Party A is not itself directly engaged in a trade or business for Section 162 purposes, and it has no employees. Party A contracts with an unrelated management company to provide management services on Party A's behalf to the joint venture. Because the management company is operating as a delegate of Party A, its actions with respect to the joint venture are attributed to Party A and such actions, when aggregated with Party A's activities, are likely to satisfy the ATB Activity Test (described below). Although Party A does not directly provide services and does not hold a profits interest, Party A's interest in the joint venture is likely an API. 
On the other hand, some profits interests held by service providers in connection with their services are not APIs. For example, consider a structure in which an operating company that does not engage in an ATB is owned by a partnership which issues profits interests to the senior management of the operating company. If the operating company is classified as a corporation or a partnership, the profits interests are exempted from classification as APIs because (i) they have been issued by the issuing partnership to employees of another entity that does not conduct an ATB and (ii) the employees do not perform services for the issuing partnership. The exemption would apply regardless of whether the issuing partnership or related persons are engaged in an ATB. If the operating company is a disregarded entity, this exemption for employees of another entity may not apply, but the profits interests will not be APIs if the operating company (and therefore its senior management) is not involved in the conduct of an ATB after accounting for the aggregation of all activities engaged in directly or indirectly by the operating company and all related persons.

Proposed Regulations

Certain key provisions set forth in the Proposed Regulations, and adopted in the Final Regulations without change, are summarized below:

  • The Proposed Regulations confirmed that, as noted above, Section 1061's three-year holding period requirement applies only to gains that are characterized as either long-term or short-term under Section 1222.
  • The Proposed Regulations specified that Section 1061 affects all taxpayers who hold APIs directly or indirectly through passthrough entities, including S corporations and qualified electing funds (QEFs).
  • The Proposed Regulations addressed the application of holding period rules under Section 1223 to the disposition of any partnership interest that is composed of one or more profits interests and one or more capital interests by specifying that the portion of the holding period to which a profits interest relates is determined based on the relative fair market value of the profits interest at the time of the disposition of all, or part, of the interest (and not at the time that the profits interest is acquired).2
  • As noted above, in order for an interest in a partnership to be an API, the interest must be held or transferred in connection with the performance of substantial services in an ATB. An ATB is any activity for which the "ATB Activity Test" is met. Under the Proposed Regulations, the "ATB Activity Test" was satisfied if the taxpayer or a person related to the taxpayer (or any of their respective agents and delegates) undertakes actions relating to raising or returning capital and investing in (or disposing of), or developing, certain Specified Assets3 (each such activity, a "Specified Action") in a manner that rises to the level of a trade or business under Section 162. The Proposed Regulations provided that the ATB Activity Test may be satisfied in a taxable year even if, during that year, the Specified Actions consist only of raising or returning capital or only of investing or developing Specified Assets.4 Nevertheless, an application of the ATB Activity Test to investments in partnership interests requires an assessment of whether the investing or developing actions sufficiently relate to Specified Assets, based on the portion of the value of the issuing partnership's assets consisting of Specified Assets relative to the value of the issuing partnership's assets as a whole.5
  • The Proposed Regulations imposed additional reporting requirements on taxpayers who directly or indirectly hold APIs, as well as partnerships that issue APIs. Failure to adhere to these reporting requirements may result in penalties and an IRS determination that all gain recognized by the taxpayer with respect to an API is subject to recharacterization.6
  • Section 1061(b) provides that, to the extent provided by Treasury and the IRS, Section 1061 will not apply to gain "attributable to any asset not held for portfolio investment on behalf of third party investors." This exception (the "third party investor requirement") was not implemented by the Proposed Regulations.7

The Final Regulations retain the structure of the Proposed Regulations, but also significantly revise the Proposed Regulations in some respects. Following the receipt of comments, the IRS made changes to the Proposed Regulations primarily in four areas: (i) the capital interest exception; (ii) the treatment of capital interests acquired with loan proceeds; (iii) the lookthrough rule for certain API dispositions; and (iv) transfers of APIs to Section 1061(d) related persons.

Capital Interest Exception

Congress intended that Section 1061 generally should not apply to recharacterize long-term capital gains and losses that truly represent a return on a partner's invested capital (including gains and losses arising in connection with a partnership interest (or portion thereof) the value of which was subject to tax under Section 83 upon receipt or vesting). Reflecting such intent, Section 1061(c)(4)(B) provides that an API does not include "any capital interest in the partnership which provides the taxpayer with a right to share in partnership capital commensurate with (i) the amount of capital contributed (determined at the time of receipt of such partnership interest), or (ii) the value of such interest subject to tax under section 83 upon the receipt or vesting of such interest."

The Proposed Regulations construed the capital interest exception quite narrowly and provided that, in order to be excepted from Section 1061 as gain attributable to invested capital, (i) gain allocated to a holder of an API (an "API Holder") must be made in proportion to the relative value of the API Holder's capital account, but for this purpose, the API Holder's capital account did not include any amounts contributed by the API Holder that had been loaned, advanced, or guaranteed by the partnership, any other partner, or any person related to the partnership or another partner, (ii) unrelated non-service partners must have a significant aggregate capital account balance (i.e., five percent or more of the aggregate partnership capital at the time of the allocation), (iii) the allocations of long-term capital gain or loss with respect to the API Holder's capital interest generally must be made in the same manner as such allocations are made to the unrelated non-service partners, and (iv) allocations to the API Holder with respect to its capital interest were required to be clearly identified both under the partnership agreement and on the partnership's books and records as separate and apart from allocations made with respect to the API. Allocations meeting the four requirements above generally were treated as "Capital Interest Allocations" under the Proposed Regulations. With respect to requirement (i), above, commentators expressed concern that managers of hedge funds, venture capital funds and private equity funds that allocate based on targeted allocations or other methods instead of Section 704(b) capital accounts would not be able to use the capital interest exception.

Generally speaking, the Final Regulations broaden the capital interest exception by providing that an allocation to an API Holder with respect to its capital interest will be considered a Capital Interest Allocation if it is determined and calculated in a "similar manner" to the allocations with respect to capital interests held by similarly situated unrelated non-service partners who have made significant aggregate capital contributions, as clearly identified in the partnership agreement and the partnership's books and records. Specifically, under the "similar manner" test, allocations and distribution rights with respect to API Holders' capital interests and the capital interests of such unrelated non-service partners must be "reasonably consistent." And, as explained further below, contributions of capital attributable to the proceeds of a loan made by another partner to the API Holder are respected as capital contributions for purposes of applying the similar manner test if the loan satisfies certain requirements. However, under both the Proposed Regulations and the Final Regulations, allocations to API Holders will fail to qualify for the capital interest exception unless commensurate allocations are also made by the partnership to unrelated non-service partners that hold five percent or more of the aggregate capital account balance of the partnership at the time the allocations are made.

The "similar manner" test under the Final Regulations may be applied on an investment-by-investment basis or on the basis of allocations made to a particular class of interests. In applying such test, the following factors are relevant in determining whether allocations with respect to similarly situated partners are reasonably consistent:

  • the amount and timing of capital contributed,
  • the rate of return on capital contributed,
  • priority of distributions, 
  • the terms associated with capital contributed (including the type and level of risk associated with capital contributed), and
  • the rights to cash or property distributions during the partnership's operations and on liquidation.

The Final Regulations follow the Proposed Regulations in providing that an allocation to an API Holder will not fail to qualify for the capital interest exception solely because such allocation is (i) subordinated to allocations made to unrelated non-service partners or (ii) is not reduced by the cost of services provided by the API Holder or a related person to the partnership. The Final Regulations clarify the cost-of-services rule by providing that an API Holder may qualify for the capital interest exception even where the partnership does not charge management fees on their capital, or where their capital is not subject to allocations of carried interest. Furthermore, API Holders are permitted to receive tax distributions even in situations where non-service partners do not, as long as such distributions are treated as advances against the API Holders' future distributions. 

Finally, the Final Regulations clarify that profits allocated to an API Holder but retained by the partnership are treated as a contribution to the partnership by the API Holder for a capital interest, which may allow future allocations of gain to the API Holder to qualify, in part, for the capital interest exception.

Treatment of Capital Interests Acquired with Loan Proceeds 

As discussed above, the Proposed Regulations generally limited the application of the capital interest exception to any allocation of gain attributable to the contribution to the partnership of any amounts that had been loaned, or guaranteed, by the partnership, another partner, or any person related to the partnership or another partner. The Final Regulations take a more measured approach, by providing that an allocation will not be treated as a Capital Interest Allocation if such allocation is attributable to a contribution to the partnership that can be attributed to a loan or advance from the partnership or another partner in the partnership (or any person related to the partnership or another partner), unless the allocation is attributable to a contribution made by an individual service provider that is attributable to a loan or advance from another partner in the partnership (or any person related to another partner, other than the partnership) if the individual service provider is personally liable for the repayment of such loan or advance. If a disregarded entity wholly owned by the individual service provider is the primary obligor on such a loan, the individual service provider must be personally liable for the repayment of any borrowed amounts that are not repaid by the disregarded entity in order to qualify for the exception. An individual service provider is "personally liable" only if (i) the loan is fully recourse to the individual service provider; (ii) the individual service provider has no right to reimbursement from any other person; and (iii) the loan is not guaranteed by any other person.

The Preamble to the Final Regulations ("Preamble") appears to clarify that if an API Holder receives an allocation of gain that relates only in part to a capital contribution attributable to a loan from the partnership or from another partner (or person related to another partner) and such loan does not satisfy the recourse requirements above, such allocation would be ineligible for the capital interest exception with respect to the portion of the capital contribution attributable to the borrowing.

Lookthrough Rule for Certain API Dispositions

Under the Proposed Regulations, a limited "Lookthrough Rule" would recharacterize all or a portion of the recognized gain from the sale of an API where the API Holder had a holding period in excess of three years in two situations.

First, in the case of a directly-held API, the Proposed Regulations would apply the Lookthrough Rule if at least 80 percent of the assets of the partnership (determined based on fair market value) would produce short-term capital gain under Section 1061 if sold by the partnership due to having a holding period of three years or less (the "Substantially All Test"). Second, the Lookthrough Rule would apply to directly-held APIs and indirectly-held APIs, including with respect to tiered partnership structures, where the underlying assets subject to the Substantially All Test are not subject to control or reporting oversight by the applicable taxpayer.

The IRS and Treasury received comments to the Proposed Regulations indicating that, while application of the Lookthrough Rule to directly-held APIs was reasonable, its application to indirectly-held APIs imposed an unreasonable and significant administrative burden on taxpayers. In response to comments, the IRS and Treasury modified the Lookthrough Rule in the Final Regulations. Instead of applying the Lookthrough Rule to the disposition of an API held for more than three years whenever the Substantially All Test is met, the Final Regulations limit the application of the Lookthrough Rule to situations where, at the time of disposition of an API held for more than three years:

  • the API would have a holding period of three years or less if the holding period of such API were determined by not including any period prior to the first date on which an unrelated non-service partner was legally obligated to make a substantial contribution of money or property directly or indirectly to the passthrough entity to which the API relates; or
  • a transaction or series of transactions has taken place with a principal purpose of avoiding potential gain recharacterization under Section 1061.

The new approach taken by the Final Regulations is intended to curb abusive transactions where taxpayers transfer assets to, or issue APIs from, existing partnerships in an attempt to avoid an application of Section 1061.

Transfers of APIs to Section 1061(d) Related Persons

Under the Proposed Regulations, a related party rule under Section 1061(d) (the "Related Party Rule") would provide that when an API Holder transfers an API to a related person, the recognition of capital gain is accelerated, regardless of whether the transfer is otherwise a taxable event. The Proposed Regulations clarified that for purposes of the Related Party Rule, the term "transfer" would include contributions, distributions, sales and exchanges, and gifts.

Not surprisingly, the IRS and Treasury received several comments to the Proposed Regulations indicating that Section 1061(d) should be interpreted as a recharacterization provision rather than an acceleration provision. In a significant change, the Final Regulations adopt these comments. The Preamble states that in the absence of clear language to the contrary, it is more appropriate to apply Section 1061(d) only to related party transfers in which long-term capital gain would otherwise be recognized under Chapter 1 of the Code. Accordingly, the Final Regulations provide that the recharacterization amount under Section 1061(d) includes only long-term capital gain recognized by the taxpayer on a taxable transfer through a sale or exchange of an API to a Section 1061(d) related person. For this purpose, the recharacterization amount is the taxpayer's share of the amount of net long-term capital gain from assets held for three years or less that would have been recognized if the partnership had sold all of its assets for fair market value in a hypothetical sale immediately prior to the sale or exchange of the API.

The IRS and Treasury received a separate comment arguing that Section 1061(d) should not recharacterize section 1231 gain, stating from a policy perspective that the Final Regulations should not impose on taxpayers a result under Section 1061(d) that is more restrictive than if Section 1061(a) had applied to assets sold by the partnership. The IRS and Treasury adopted this comment in the Final Regulations, and by implication will limit the recharacterization amount for purposes of Section 1061(d) to amounts that would be recharacterized under Section 1061(a) (i.e., net long-term capital gain from assets held for three years or less, but not gain under Section 1231, Section 1256, etc. that otherwise would be excluded).

Applicability Dates

The Final Regulations generally will be applicable to taxable years beginning on or after January 19, 2021, (i.e., the date they are being published in the Federal Register). However, the rule treating S-corporations as passthrough entities and not as corporations for purposes of Section 1061 applies to taxable years beginning after December 31, 2017, and the rule treating QEFs as passthrough entities and not as corporations for such purposes applies to taxable years beginning after August 14, 2020.

Notably, for purposes of the Congressional Review Act, the Treasury Department and the IRS have determined that the 60-day delay in the effective date after publication in the Federal Register generally applicable to a "major rule" would be unnecessary and contrary to the public interest; accordingly, the Final Regulations have an effective date of January 13, 2021, the date the Final Regulations were filed for public inspection at the Office of the Federal Register. This determination may be an effort to avoid the expected freeze on not-yet-effective regulations by the incoming Biden administration.8

Taxpayers generally may apply the Final Regulations in their entirety to a taxable year beginning after December 31, 2017, so long as they apply the Final Regulations consistently to such taxable year and all subsequent taxable years.


1. Unless otherwise indicated, all "section" references contained herein are to sections of the Code.

2.  For example, assume a partner contributes capital to a partnership for a partnership interest and later receives a profits interest in that partnership which is an API. Upon the subsequent sale of that partner's entire interest in the partnership, in order to divide such partnership interest for purposes of determining the holding period of each portion thereof, the partner must separately determine the fair market value at the time of the sale of the API. The partner will have a divided holding period in its interest in the partnership; the percentage of the partnership interest that has a holding period beginning when the partner received the API will equal the fair market value of the API when sold, divided by the fair market value of the entire partnership interest at that time. The remainder of the partnership interest has a holding period beginning when the partner acquired the capital interest.

3.  Specified Assets generally include (i) securities, (ii) commodities, (iii) real estate held for rental or investment, (iv) cash or cash equivalents, and (v) an interest in a partnership to the extent that the partnership holds Specified Assets.

4.  For example, the ATB Activity Test may be met on account of raising or returning capital in anticipation of making investments in Specified Assets in a later year, or investing in or developing Specified Assets using capital raised in an earlier year.

5.  For this purpose, actions taken to manage a partnership's working capital will not be taken into account as Specified Actions.

6.  Despite receiving many comments requesting exceptions and other relief from the Proposed Regulations' reporting requirements, in the Final Regulations, the IRS and Treasury retain the reporting rules as proposed with minor clarifying changes.

7.  Treasury and the IRS continue to study Section 1061(b) and may address its application in future guidance. The Final Regulations do apply the third-party investor requirement in one circumstance, by providing that the delayed holding period prong of the Lookthrough Rule does not apply to the disposition of an API to the extent the gain recognized is attributable to any asset not held for portfolio investment on behalf of third-party investors.

8.  Several media outlets have reported that the Biden administration intends to issue an order halting or delaying any so-called "midnight regulations" (i.e., regulations issued after election day that have not taken effect by January 20, 2021).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.