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By: Michele J. Alexander, Barnes & Thornburg

On Jan. 7, 2021, the Internal Revenue Service (IRS) and the Treasury Department issued final regulations regarding the treatment of carried interests, or profits interests in partnerships that generally entitle service providers to share in appreciation at capital gains rates. Fund managers generally will be pleased that these final regulations removed or scaled back some of the more onerous provisions of the prior proposed regulations.

In particular, aggressive related party transfer rules were reworked and the complex exception to the rules for certain capital interests has been modified.

Nevertheless, these final rules are the latest chapter in the effort to prevent fund managers from paying tax at capital gains rates when, in the view of the government, they are being compensated for services provided.

Section 1061 of the Internal Revenue Code (the Code) was enacted in 2017. That section generally recharacterizes gain resulting from the sale of an "applicable partnership interest" (API) as short-term capital gain where the holding period of the interest is less than three years, notwithstanding that the general holding period requirement for long-term capital gain is one year. Section 1061 defines as an API a partnership interest held by, or transferred to, a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or by any other related person, in any appl......................

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