On July 31, 2020, the US Internal Revenue Service (the "IRS") issued long-awaited proposed regulations (the "Proposed Regulations") providing guidance under Section 1061 of the Internal Revenue Code of 1986, as amended (the "Code"). The Proposed Regulations are of interest to taxpayers that engage in investment activity through private investment fund partnerships and other joint venture arrangements.


A carried interest generally refers to a profits interest in a partnership that is issued in connection with the performance of services, typically representing a fund sponsor or other service provider's incentive compensation for meeting targeted performance goals. For carried interest received from certain investment partnerships, the 2017 Tax Cuts and Jobs Act introduced a three-year holding period requirement in order to qualify for long-term capital gain treatment. Capital gain received as carried interest that does not satisfy the three year holding period requirement is treated as short-term capital gain and taxed at higher ordinary income tax rates.

The Proposed Regulations provide guidance for identifying the types of partnership interests and underlying trades or businesses that are subject to the three-year holding period requirement. The Proposed Regulations also outline various exceptions and provide detailed operational rules for calculating the amount of gain that is recharacterized as short-term capital gain. In addition, the Proposed Regulations establish rules for accelerating and recharacterizing built-in gain inherent in carried interests that are transferred to related parties, even for certain transfers that would not otherwise be taxable events. Finally, the Proposed Regulations include rules for providing reporting information necessary for taxpayers to comply with Section 1061.

Key Definitions

Applicable Partnership Interests. Section 1061 applies to any applicable partnership interest ("API"), which is an interest in a partnership that, directly or indirectly, is transferred to (or held by) a taxpayer in connection with the performance of substantial services by the taxpayer, or by any other related person, in any applicable trade or business ("ATB").1 An API may be held indirectly through one or more tiers of pass-through entities, including partnerships, S corporations, or any passive foreign investment company with respect to which a qualified electing fund election is in effect. For this purpose, an interest in a partnership also includes any financial instrument or contract, the value of which is determined in whole or in part by reference to the partnership. Once a partnership interest qualifies as an API, the interest remains an API unless and until an exception applies. For example, if a general partner holding a carried interest in an investment partnership retires and retains its carried interest but ceases providing services to the partnership, the interest remains an API even after the general partner retires.2

Applicable Trades or Businesses. For a partnership interest to be an API, the interest must be held or transferred in connection with the performance of services in an ATB. An ATB is any activity that meets the "ATB Activity Test" with respect to "Specified Actions."

ATB Activity Test. The ATB Activity Test is met if Specified Actions are conducted by one or more related persons and the total level of combined activities is sufficient to establish a trade or business under Section 162. The Proposed Regulations bifurcate activities that constitute Specified Actions into two broad categories: (1) raising or returning capital actions and (2) investing or developing actions. Investing or developing actions must be conducted with respect to "Specified Assets," which include commodities, real estate held for rental or investment, cash or cash equivalents, or interests in partnerships to the extent the partnership holds Specified Assets. However, management of working capital assets is not taken into account for purposes of the ATB Activity Test. It is not necessary to conduct both categories of actions each year in order to satisfy the ATB Activity Test. For example, taking a small number of actions to raise capital for new investments combined with taking numerous actions to make or manage new or existing investments are both taken into account and may be sufficient to satisfy the ATB Activity Test.3 The Proposed Regulations also provide that actions of related persons (including recent former colleagues) and of agents or delegates are taken into account. Consequently, where a fund general partner contracts with a management company to provide services to the fund on the general partner's behalf, the actions of the management company will be attributed to the general partner.4

API Gains and Losses. API Gains and Losses refer to any long-term capital gains and losses with respect to an API and are the amounts that factor into the calculation of how much of a taxpayer's long-term capital gain will be recharacterized as short-term capital gain (i.e., the Recharacterization Amount). All long-term capital gains and losses with respect to a taxpayer's APIs are aggregated for this purpose, including the taxpayer's distributive shares of gain or loss from all APIs and the taxpayer's gain or loss from the disposition of APIs held during the year. Certain types of capital gains are excluded from a taxpayer's API Gains and Losses, perhaps most notably Section 1231 gains earned by many real estate partnerships and Section 1256 gains earned by many hedge fund partnerships. Other exclusions apply for gains and losses that are attributable to assets held for more than three years as of January 1, 2018 if the applicable partnership has elected to apply a transition rule. As noted below, a capital interest in a partnership is excluded from the definition of an API, and thus gains and losses received with respect to capital interests in partnerships are not API Gains and Losses.

Interaction with Revenue Procedures 93-27 and 2001-43

Revenue Procedure 93-27 defines a profits interest and provides a safe harbor pursuant to which the receipt of a profits interest is not treated as a taxable event. Revenue Procedure 2001-43 clarifies Revenue Procedure 93-27 and provides guidance on the treatment of grants of profits interests that are substantially nonvested at the time of issuance. The Proposed Regulations state that Section 1061 applies to all partnership interests that meet the definition of an API, regardless of whether the receipt of the issuance is a taxable event under Revenue Procedure 93-27. The Proposed Regulations also state that no inference should be drawn as to the application of Revenue Procedure 93-27 to arrangements where one party provides services and another party receives a an associated carried interest allocation. It appears the intention of this statement is to decouple the application of the Proposed Regulations to a carried interest from the IRS's 2015 proposal to modify the safe harbor set forth in Revenue Procedure 93-27 such that the safe harbor would not apply to fee waivers that benefit a related party.


1 Prop. Treas. Reg. § 1.1061-1(a).

2 Prop. Treas. Reg. § 1.1061-2(a)(2), Example 1.

3 Prop. Treas. Reg. § 1.1061-2(b)(1), Example 1.

4 Prop. Treas. Reg. § 1.1061-2(b)(2), Example 5.

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