On July 31, 2020, the Internal Revenue Service (IRS) published proposed regulations providing guidance under Section 1061 (the "Proposed Regulations") of the Internal Revenue Code (the "Code"). Section 1061, which was added to the Code by the Tax Cuts and Jobs Act, serves to limit the so-called "carried interest loophole" 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, the approaches taken in the Proposed Regulations are in line with practitioners' expectations, although certain provisions (and, in particular, those relating to the exception for capital interests) provide more stringent rules that many practitioners had been anticipating.

Once the Proposed Regulations are finalized, they generally will apply to taxable years beginning on or after the date on which the final regulations are published, but taxpayers may rely on the Proposed Regulations, provided they follow the Proposed Regulations in their entirety and in a consistent manner.

The following summarizes the key points of the Proposed Regulations.


The Proposed Regulations provide guidance for determining the amount of a taxpayer's long-term capital gain recharacterized as short-term capital gain pursuant to Section 1061. Notably, the Proposed Regulations confirm 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. Additionally, the Proposed Regulations specify that Section 1061 affects all taxpayers who hold APIs directly or indirectly through passthrough entities. Consequently, as announced by the IRS in March 2018 (in Notice 2018-18), taxpayers who hold APIs through an S corporation are subject to Section 1061, despite the fact that Section 1061, by its terms, does not apply to partnership interests directly or indirectly held by a "corporation."

The Proposed Regulations also clarify the application of holding period rules under Section 1223 to any partnership interest that is comprised of one or more profits interests and one or more capital interests, and specify that the holding period for the partnership interest shall be determined separately as to each such profits interest or capital interest based on the relative fair market value of each (which clarification is necessary for the application of Section 1061 to the disposition of part but not all of such partnership interest).

Finally, the Proposed Regulations impose 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 a partnership is subject to recharacterization.

The Proposed Regulations

Key Definitions

  • API. An API is a partnership interest (or any financial instrument or contract valued by reference to the partnership) that is transferred to or held by a taxpayer (directly or through a passthrough entity)1 in connection with the performance of substantial services2 in an "applicable trade or business" by the taxpayer, its agent or delegate, or any "related person."3 The Proposed Regulations provide a number of exceptions to the definition of API, as described below under "Exceptions to the Definition of an API." An API remains an API unless and until one of the exceptions is satisfied.
  • API Gains and Losses. API Gains and Losses are the long-term capital gains and losses recognized with respect to an API, which factor into the determination of a taxpayers' net long-term capital gain with respect to APIs. The Proposed Regulations provide that the taxpayer's net long-term capital gain with respect to all APIs held directly or indirectly by the taxpayer during the taxable year includes the taxpayer's combined net distributive share of the API Gains and Losses of passthrough entities, as well as any long-term capital gain and loss from the taxpayer's disposition of any APIs during the taxable year. Notably, the Proposed Regulations specify that API Gains and Losses do not include long-term capital gain determined under Sections 1231 and 1256, qualified dividends taxed as long-term capital gains pursuant to Section 1(h)(11)(B), and any other capital gain that is characterized as long-term or short-term without regard to the holding period rules in Section 1222.
  • Applicable Trade or Business (ATB). An ATB is any activity for which the ATB Activity Test is met relating to actions undertaken by the taxpayer or any related person with respect to raising or returning capital and investing in (or disposing of), or developing, certain Specified Assets (each such activity, a "Specified Action").
  • ATB Activity Test. The Proposed Regulations introduce a new concept referred to as the "ATB Activity Test," which is satisfied if Specified Actions are conducted by the taxpayer and one or more related persons (and their agents and delegates) with respect to Specified Assets in a manner that rises to the level of a trade or business under Section 162. The Proposed Regulations clarify 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. 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. 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. For this purpose, actions taken to manage a partnership's working capital will not be taken into account as Specified Actions.
  • Specified Assets. 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. "Securities" for this purpose includes interests in partnerships qualifying as securities under Section 475(c)(2)(B), which is confined to partnerships that are publicly traded or widely-held. By implication, interests in partnerships that are not publicly-traded or widely held should not be characterized as Specified Assets, unless the issuing partnership holds Specified Assets (and only to the extent of such Specified Assets).

Exceptions to the Definition of an API

  • Partnership Interests Held by an Employee of Another Entity Not Conducting an ATB. The Proposed Regulations provide that a partnership interest transferred to an employee of another entity will not constitute an API if such entity does not conduct an ATB, either on its own or together with related persons, and the employee provides services only to such entity.
  • Partnership Interests Held by a Corporation. A partnership interest held by a corporation will not constitute an API unless the corporation is an S corporation or the corporation is a passive foreign investment company with a qualified electing fund (QEF) election in effect.
  • Capital Interest Allocations. A partnership interest (or portion thereof) with respect to which allocations of capital gain or loss are made in proportion to the holder's capital account balance is not an API.
  • Partnership Interests Acquired by Purchase by an Unrelated Taxpayer. A taxpayer will not be treated as acquiring an API when acquiring a partnership interest for fair market value in a taxable purchase if the taxpayer has not provided, and will not provide, services to the partnership, directly or indirectly, and is not related to any person who provides, or has provided, services to the partnership (directly or indirectly) or in a relevant ATB.
  • Family Office Exception. The Proposed Regulations reserve for later guidance rules implementing Section 1061(b), which provides that recharacterization shall not apply to gain attributable to any asset not held for portfolio investment on behalf of third-party investors. For this purpose, a third-party investor is a person who holds an interest in the partnership that does not constitute property held in connection with an applicable ATB and does not provide substantial services for such partnership or for any ATB.

Recharacterization of Gain

  • Sale of API or Passthrough Interest. Generally, when an API is sold, the capital gain will only be recharacterized as short-term capital gain if the holding period in the interest does not exceed three years. However, the Proposed Regulations apply a look through rule for the direct or indirect sale of APIs with holding periods exceeding three years in two circumstances. First, if an API is sold by its direct holder and 80 percent or more of the assets of the partnership that issued the API (based on fair market value) are assets with a holding period of three years or less that would produce capital gain or loss subject to recharacterization if disposed of by the partnership, then the issuing partnership meets a "substantially all" test and the seller of the API must look through to the holding periods of the partnership's assets. Second, in a tiered partnership structure, where an upper-tier partnership owns an API in a lower-tier partnership, if the taxpayer's holding period exceeds three years, but the upper-tier partnership's holding period for its interest in the lower-tier partnership does not exceed three years or the "substantially all" test above is met by the lower-tier partnership, then the holding period of the taxpayer's gain attributable to the lower-tier partnership is determined with respect to the upper-tier partnership's holding period (or the holding period of the lower-tier partnership in its assets, as the case may be).
  • Allocation of Gain from an API. In a tiered structure of passthrough entities, API Gains and Losses, including API Gains and Losses not yet realized, retain their character as they are allocated throughout the tiers of the structure. Thus, for example, if an individual contributes capital to an upper-tier partnership to acquire a partnership interest, that individual's share of the API Gains and Losses allocated to the upper-tier partnership will retain their character as API Gains and Losses despite the capital investment by the individual.
  • No Recharacterization of Gains Attributable to Certain Capital Interests. Long-term capital gains and losses that represent a return on an API holder's invested capital are excepted from recharacterization under Section 1061. To be excepted from Section 1061, gain allocated to a holder of an API must be made in proportion to the relative value of the holder's capital account (generally including unrealized gains and losses, but expressly excluding the contribution of amounts loaned, advanced, or guaranteed by the partnership, any other party, or any person related to the partnership or other party). The exception for capital interests applies only to the extent that a service provider's rights with respect to its contributed capital match the rights of other non-service partners with respect to their shares of contributed capital.
  • Acceleration Rule Where Transferred to a Related Party. Section 1061(d) provides that when a taxpayer transfers an API to a related person, the recognition of capital gain is accelerated, regardless of whether the transfer is an otherwise taxable event, except where the transfer is to a partnership where section 721 applies to provide for nonrecognition treatment. The Proposed Regulations clarify that the definition of "related person" for purposes of Section 1061(d) was intended to be construed narrowly and specify that the term includes only (i) family members, (ii) colleagues (i.e., any person who provided services in the calendar year or three preceding calendar years in the relevant ATB), and (iii) any passthrough entity owned in whole or in part by persons described in (i) or (ii); this definition is narrower than the definition used for purposes of determining whether a partnership interest is an API.
  • Distributed API Property Rule. If a taxpayer receives an in-kind distribution of a capital asset with respect to an API (i.e., a "Distributed API Property"), the long-term capital gain on the ultimate disposition of the Distributed API Property will be subject to recharacterization if the Distributed API Property is held for not more than three years at the time of such disposition. The Proposed Regulations clarify that the holding period of the Distributed API Property in the taxpayer's hands includes the partnership's holding period with respect to the Distributed API Property prior to the date of the in-kind distribution, consistent with Section 1223.
  • Carried Interest Waivers. The preamble to the Proposed Regulations indicates that Treasury and the IRS are aware that taxpayers may seek to circumvent Section 1061 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 (such arrangements or substantially similar arrangements, "Carried Interest Waivers"). The preamble to the Proposed Regulations warns that taxpayers should be aware that Carried Interest Waivers may not be respected and may be challenged under various principles of Subchapter K and judicial doctrines.


The Proposed Regulations provide much needed guidance to owners and issuers of partnership interests issued in connection with the performance of services. Aside from the new reporting requirements, the Proposed Regulations mainly serve to confirm consensus interpretations of the substance of Section 1061 and thus, generally, should not require major changes to the practices already in place at impacted equity funds.


1.  A holder of an API may be an individual, partnership, trust, estate, S corporation or certain passive foreign investment companies.

2.  The Proposed Regulations create a presumption that if partnership interest is transferred in connection with services, the services were substantial.

3.  A "related person" means a person or entity who is treated as related to another person or entity under Section 707(b) or 267(b).

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.