ACTEC Comments on Treasury’s Proposed Regulations Under Section 1061
“ACTEC’s Comments on Treasury Proposed Regulations Under Section 1061,” that is the subject of today’s ACTEC Trust and Estate Talk.
This is Constance Tromble Eyster, ACTEC Fellow from Boulder, Colorado. On October 5th, 2020, ACTEC submitted comments to US Department of Treasury regarding proposed regulations issued under Section 1061 of the Code. That section of the code addresses capital gains treatment of transfers of applicable partnership interests. ACTEC submitted comments addressing how the proposed regulations address transfers of such partnership interests to non-grantor trusts that benefit of grantor’s immediate family members and address the exclusion for partnerships without third-party investors. To learn more about these regulations and ACTEC’s comments, we will be hearing today from ACTEC Fellow Kevin Matz of New York, NY. Welcome Kevin.
Background on IRS Code Section 1061
Thank you, Connie. The background here is we are talking about Section 1061 — came in with the Tax Cuts and Jobs Act of 2017, December 2017, and its target here: carried interest in private investment funds. When I am talking about private investment funds, I am referring to private equity funds. It could also be hedge funds, real estate funds, basically financial instruments. And, we are talking about carried interest, which are a species of profits interest. So, usually with private investment funds you have the owners, or the founders of the fund have two different sources of income. One is by virtue of being a fund manager. Okay.? So, there is usually an entity that receives a fund management fee; and then, they have the so-called profits interest or carried interest in the fund. The way that works is as follows.
Whereas the fund management fee usually, I am generalizing here, but usually will be ordinary income. With the carried interest it says this — the deal for them is basically structured as follows: a certain benchmark needs to be achieved as far as return on investment to the investors in the fund. And, it is quite also possible that there could be a side-by-side co-investment by the fund managers. They can do that too. But let’s put that aside for now. If that benchmark is achieved, and let’s say it is 8 percent or 9 percent, whatever is set forth in the fund document, then anything above that – there is some sort of extra allocation that then goes to the general partners, in which the founders of the fund have the fund manager, have the interest, the so-called carried interest. Quite often, this is structured. It does not have to be, but it can be structured as a 2 and 20, which means a 2 percent management fee; and again that generally will be taxed as ordinary income. Then, you have the carried interest, which is that allocation above that benchmark. There could be certain clawbacks and certain aspects of it that will vary from fund to fund. It is all contractual. And, that will go to the general partner and that will be taxed under current law as capital gain income, not ordinary income but rather capital gain income. So, that is where Section 1061 comes in.
Now going back quite a few years, we are talking about going back to about 2006 or 2007, there abouts. There have been attempts by Congress to enact legislation that says, we have capital gain here but the capital gain here is to people who are putting sweat equity into developing this fund and getting investors and managing investments, and the like. Isn’t that what they are doing more akin to sort of working for a living and rendering services and being compensated for services? If they are compensated for services, isn’t that something that should be taxed as ordinary income? There have been various proposals that have targeted that, that have not been accepted effectively by Congress until we got to 2017 with Section 1061, which was enacted.
Requirements Under 1061
1061 basically says this — we are not going to treat it as ordinary income, but we are going to impose some requirements, and those requirements are going to say a couple of things relevant to folks in the trust and estate realm. Couple things. So, number one, you have to have a three-year holding requirement here. If you were to sell your interest in the carry or in the general partner, that in return owns the carry, within three years; even though there is usually a one-year holding period to go from short-term capital gain to long-term capital gain, we are going to impose a three-year requirement. Now why is that significant? That is significant because if you have short-term capital gain, you are taxed just like it is ordinary income, which means you are subjected to higher tax rates. It could be 37 percent and more on top of that, as opposed to 20 percent for long-term capital gain. So that’s number one. You have the conversion, if you are in the period from one year to three years as far as taxation as short-term capital gains, which is treated the same way as ordinary income.
Secondly, also in Section 1061, the concern that Congress had was, what if a fund manager were to transfer their interest to a lower tax party, such as a child, or it could be a parent, or a grandparent? It could also potentially be a spouse. What happens then? The concern that Congress has is that could be a vehicle to basically swap tax rates for a lower tax rate. So, what Congress did was, with Section 1061, they inserted subsection (d), 1061(d), which says, if there is a transfer to a related party directly or indirectly, to a related party within the meaning of Section 318(a)(1), we will talk about that shortly. If you do that within that three-year window, that is a deemed sale; and that is going to be an acceleration event and you are going to be treated as though you had a sale and if you are in that three-year window, you are converted from long-term capital gain to short-term capital gain taxes — ordinary income tax rates. So, that sets the background. That came in 2017 with Tax Cuts and Jobs Act.
It was not until July 31 of this year that proposed regulations came out from Treasury. Those proposed regulations came out and they addressed a number of these points and tried to fill in the interstices. Now in looking at it, ACTEC focused on these proposed regulations and put together a task force. I just want to commend our working group on it. Just to mention names, Todd Angkatavanich, myself, along with Don Kozusko, Amy Heller, Steve Gorin, and Stephen Breitstone. We addressed those issues that were germane specifically in proposed regulations to trust and estates and also the family offices.
Issues Addressed in Comments Letter to Treasury
The first issue that we tackled in our comment letter was to request the Treasury to confirm that in light of Section 1061(d), specific reference to 318(a)(1), which again 318(a)(1) — related party definition: only children, grandchildren, parents, and spouse, and no one else — that if there were to be instead a gift or transfer to a non-grantor trust for the benefit of those same people, that that would not be captured by that acceleration rule. Just to take a step back, the rules were very helpful in proposed regulations under Section 1061 in spelling out that if there is a transfer or any sort of gift or other transaction, it could be a swap. It could be a sale — with a disregarded entity, it is a tax nothing. That is not going to be a trigging event under Section 1061 and 1061(d). So, that means that any transaction that we love to do in the world of estate planning with grantor trusts — it could be swaps, it could be sales, it could be gifts — not a problem. That could all be done.
Clarification Relating to Non-grantor Trust
But what if it is a non-grantor trust? The concern there was that there was a scope for that exception and how it is provided. Now, you may say children, grandchildren, parents, spouses, that does not include other parties, such as non-grantor trusts. It doesn’t include partnerships. It doesn’t include corporations. And that is true, and in fact those other parties are not within Section 318(a)(1) but rather they are within the separate Section 318(a)(2). But here is what was concerning for us. The language of 1061(d) does not just talk about direct transfers. It says transfers directly or indirectly, a direct or indirect transfer of an applicable partnership interest or API to a related person. We had some concern that Treasury could possibly say — or there could possibly be a construction down the road — that if you were to make a gift to a non-grantor trust for the benefit of children, grandchildren, parents, or spouse, that could be deemed an indirect transfer for the benefit of such persons; and therefore, be absorbed within that rule and be deemed an acceleration event, even though it was to a non-grantor trust for those persons. Again, is it likely that that is what was intended by Congress? Our thought was no, but we really wanted to get clarification, and that was the nub of what we sought. Clarification that if you look at the statutory latticework here, Congress is very clear. They talked about related parties under 318(a)(1). They could have said 318 generally. They could have said 318(a)(2), which also would include non-grantor trust. They didn’t; there was a deliberate choice of words here. And therefore, we have asked Treasury to clarify that a gift to a non-grantor trust will not be a triggering event.
Along those lines, a couple of related points that we also asked Treasury to clarify was presumably the death of a holder of this applicable partnership interest. Again, that is, I think, in terms of the carried interest in the private investment fund — that should not be a triggering event. Makes sense that it wouldn’t be because an estate is covered by 318(a)(2) as opposed to 318(a)(1). We asked Treasury to clarify that too. We also asked Treasury to clarify that the 1061(d) taint goes away upon death. Again, that is an act of independent legal significance. Presumably, it should not carry over to one’s successor in interest, one’s heirs or beneficiaries.
Also, what if there is change in status from grantor trust to non-grantor trust? That could occur not only by reason of death but it could result from converting from grantor trust to non-grantor trust status, such as release of a power of substitution, for example. Or it could be because of a decanting. So, where we came out on that in our comment letter, in ACTEC’s comment letter, was to say, well, that should not make a difference. However, there should be a tacking of the holding period from grantor trust status to non-grantor trust status and is the key that is if we get past three years, including the tax period of grantor trust status, you should be okay, and not be within the scope of 1061(d) as far as that is concerned. And, we sought clarification on that too.
Clarification Relating to Family Offices
The second category of issue that we sought clarification on in our comment letter had to do with the exclusion from 1061 for family offices; 1061(b) is very clear. In terms it said that we are looking for those private investment funds, applicable partnership interests, where there are third-party investors who have put up money. Not the service providers and the family members of the service providers, but we are looking for outside money. If you do not have third-party investors, then it is not good. You are going to have the benefit of an exclusion. You are not going to be subject to Section 1061(b). Now, the preamble was very clear, that is what was intended by Congress here; and Treasury said yes, we have heard comments. The family office should not be subject to it so long as there is no outside money put up, and we agree. But then, so you say, where is the issue? Unfortunately, it was not properly implemented. That statement of intent was not properly implemented in the proposed regulations. Proposed regulations — the preamble went on to say, well, we think that there is this provision of the proposed regulations that give us so-called pass-through interest direct investment allocations. We think that is sufficient, and we do not have to say anything under — basically provide proposed regulations under 1061(b).
So, we are just going to reserve as to that, and rely upon these other provisions. And if any groups have comments, provide comments. Well, we took a look at that, and unfortunately, those provisions didn’t pass through interest in investment allocations, which, by-the-way, are very dense provisions. They deal with a completely different situation. They deal with co-investments; they deal with capital accounts. They don’t deal with a situation where you don’t have other people’s money being put up, no third-party investors; and it’s a situation that it’s solely by the service providers and their families and family offices, and trusts, and the like. So, we made a point in our comment letter to say, this is something that does need to be addressed. You are trying to have this provision here in a proposed reg. serve double duty – doesn’t work in this context. So, we need to have specific guidance provided. We also posited, well, there could be some situations that arise that aren’t going to be so clear. So, what if someone is a service provider and they leave? They leave the private investment fund, go somewhere else, retire. Do they all of a sudden become a third-party investor? Presumably, they shouldn’t be, based upon some language in the statute. So, we requested clarification there. Also, are there de minimis exceptions? What if there is some outside investment but it’s, say, less than 10 percent of the entire capital put-up. You know? Should there be some sort of de minimis rule? And then, lastly, you know, what if there in fact are outside investors, do you treat it as perhaps two different regimes of rules that apply? One that is governed by 1061, where there is the outside investment, and another that is not. So, for all those items, we sought clarification.
Also, in this connection, a question was raised. Well, how are we defining “related parties?” It wasn’t clear. What was suggested in ACTEC’s comment letter was that perhaps, Treasury, if you’re looking for definitions, maybe take a look at Section 2704(c)(2). Not 267, not 707 but 2704(c)(2). Why? Because that also admits in definition of related parties, spouses and members of the family and in-laws. And that probably is a more realistic gauge as far as what’s involved here. So, that is a summary of our comments we submitted to Treasury October 5, 2020, and we’ll see what happens from there.
Thank you, Kevin, for summarizing so well and distilling for us ACTEC’s comments to the Section 1061 Proposed Treasury Regs.
This podcast was produced by The American College of Trust and Estate Counsel, ACTEC. Listeners, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. The material in this podcast is for information purposes only and is not intended to and should not be treated as legal advice or tax advice. The views expressed are those of speakers as of the date noted and not necessarily those of ACTEC or any speaker’s employer or firm. The information, opinions, and recommendations presented in this Podcast are for general information only and any reliance on the information provided in this Podcast is done at your own risk. The entire contents and design of this Podcast, are the property of ACTEC, or used by ACTEC with permission, and are protected under U.S. and international copyright and trademark laws. Except as otherwise provided herein, users of this Podcast may save and use information contained in the Podcast only for personal or other non-commercial, educational purposes. No other use, including, without limitation, reproduction, retransmission or editing, of this Podcast may be made without the prior written permission of The American College of Trust and Estate Counsel.
If you have ideas for a future ACTEC Trust & Estate Talk topic, please contact us at ACTECpodcast@ACTEC.org.
© 2018 – 2021 The American College of Trust and Estate Counsel. All rights reserved.
Latest ACTEC Trust and Estate Talk Podcasts
“Taxes Emerging in Europe to Pay the Costs of COVID,” that’s the subject of today’s ACTEC Trust and Estate Talk. Transcript/Show Notes This is Doug Stanley, ACTEC Fellow from St. Louis, Missouri. During the COVID pandemic in many jurisdictions in Europe, there had...