On July 31, 2020, the U.S. Treasury released proposed regulations governing certain partnership interests held in connection with the performance of substantial services by a partner or related person (so called "carried interests"), addressing the 2017 tax reform provision lengthening the (lower rate) long term capital gain ownership period from one year to three years.

The regulations are proposed to be effective when finalized, but taxpayers may generally rely on them if applied fully and consistently.

What Is (and Is Not) Covered?

The three-year restriction applies with respect to carried interests held by individuals directly or indirectly through partnerships and other flow-through entities for U.S. tax purposes, including S corporations (as previously announced) and passive foreign investment companies, or PFICs, with respect to which a shareholder has a qualified electing fund, or QEF, election in effect.

Holders of carried interests that receive "capital gain dividends" from REITs and RICs are eligible for long-term capital gain treatment, if it can be shown that the capital gain dividends are attributable to capital assets held for more than three years or to property excluded from the three-year restriction.

Notable exclusions from the three-year restriction include:

• Gains on property that are eligible for long-term capital gain under certain other specific rules, including depreciable and real property used in a business (so-called "section 1231 assets");
• Qualified dividends from domestic corporations and certain foreign corporations; and
• Gains attributable to capital contributions made by the carried interest holder that are commensurate with the capital contributed, calculated by reference to the returns of unrelated partners that do not hold carried interests.

Whose Holding Period Counts?

If a portfolio investment is sold by a fund, the holding period is determined by the fund's investment period in the asset that is sold, regardless of how long a general partner has held the carried interest.

If a general partner disposes of its carried interest in the fund, its holding period in the carried interest controls, regardless of how long the fund has held its portfolio investments, unless a limited look-through rule applies. If that is the case, the general partner must look through to the fund's holding period in its underlying portfolio investments to determine whether and to what extent the three-year holding period is satisfied.

Complex computations may be required in determining the holding period of a carried interest if it constitutes a portion of an overall partnership interest, the other portions of which were received for capital contributions and/or at different times (including, for example, where capital contributions are made to fund an add-on to an existing portfolio investment).

What Is the Effect on Carry Waivers?

Carry waivers are fund provisions allowing a carried interest holder to waive entitlement to portfolio investment gains that would be subject to (higher-rate) short-term capital gain treatment, and substitute for these amounts future gains (if any) generated from remaining portfolio investments. The preamble to the proposed regulations warns against carry waivers by stating they will be subject to existing anti-abuse, substance-over-form, and economic substance doctrines, but it provides no further guideline of when such arrangements will be respected.