An Examination of the Final Carried Interest Regulations (Part One of Two)

As of 2018, carried interest holders seeking preferential tax rates for long-term capital gains have become subject to extended holding period requirements and additional compliance requirements. Among the significant tax reforms contained in the Tax Cuts and Jobs Act, Section 1061 of the U.S. Internal Revenue Code introduced a three-year holding period for long-term capital gains realized by service-provider partners in lieu of the one-year holding period that otherwise generally applies. Proposed regulations under Section 1061 were issued in August 2020 (Proposed Regulations), and final regulations were published on January 19, 2021 (Final Regulations). The Section 1061 rules introduce even greater complexity into an already complex tax regime relevant to partnerships – and additional hurdles for fund managers and their service professionals that seek tax benefits from the partnership structure. In a guest article, the first in a two-part series, Allen & Overy attorneys Dave Lewis, Caroline Lapidus and Shoshana Schorr provide the legal and legislative backdrop to the Final Regulations; compare the Proposed Regulations to the final version; and explain the Section 1061 recharacterization amount. The second article will discuss the capital interest exception; the so-called “Look-Through Rule”; related person transfers; and reporting and compliance considerations, and it will consider possible future changes to the law under the Biden administration. See our four-part series on taxation of carried interests for senior-level fund managers: Part One (Mar. 7, 2019); Part Two (Mar. 14, 2019); Part Three (Mar. 21, 2019); and Part Four (Mar. 28, 2019); as well as our two-part series on internal compensation arrangements for investment professionals: “Carried Interest and Deferred Compensation” (Mar. 15, 2018); and “Hedge Fund Compensation and Non-Competes” (Mar. 22, 2018).

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