December 2, 2021

Volume XI, Number 336

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Co-Investment Vehicles Under the Final Carried Interest Regulations

As a result of final Treasury Regulations issued by the IRS under Section 1061,fund sponsors should consider investing capital through a commingled fund with other investors as opposed to using its own investment vehicle to invest in parallel with the fund, which could be subject to the three-year holding period requirement under Section 1061.

Section 1061 recharacterizes certain net long-term capital gain with a holding period of less than three years as short-term capital gain at ordinary income rates.  Section 1061 applies to an “applicable partnership interest” (an “API”) held by or transferred to a taxpayer in connection with the taxpayer’s performance of substantial services in an applicable trade or business.  Carried interest arrangements can constitute an API, which would be subject to the three year holding period. 

However, a “capital interest” in a partnership is generally not an API (the “Capital Interest Exception”).  For this purpose, a capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value at the time the interest was received and the proceeds were then distributed in a complete liquidation of the partnership.  Accordingly, a fund sponsor holding may be able to structure a portion of its investment to be excepted from Section 1061 (and the three-year holding period) with respect to its invested capital under the Capital Interest Exception.

In order for the fund sponsor to meet the Capital Interest Exception, allocations with respect to its capital interest must be reasonably consistent with and determined in a similar manner to the allocation and distribution rights that apply to the capital invested by unrelated non-service providers that have made significant capital contributions (defined as 5% or more of the aggregate capital account balance of the partnership at the time the allocations are made).  The regulations provide the following non-exclusive factors for applying this test: (i) the amount and timing of capital contributed; (ii) the rate of return on capital contributed; (iii) the terms, priority, type and level of risk associated with capital contributed; and (v) the rights to cash or property distributions during the partnership’s operations and on liquidation.

As drafted, it would be challenging to have interests in a fund sponsor’s co-investment vehicle qualify for the Capital Interest Exception because allocations must be compared relative to those made to significant unrelated non-service providers.  The Treasury and the IRS continue to study the application of the Capital Interest Exception to co-invest vehicles.

Provided that the fund’s partnership agreement and books and records clearly demonstrate the requirements listed in the foregoing, the fund sponsor could co-invest in the underlying portfolio investment through a commingled fund with unrelated non-service providers.  By contrast, a fund sponsor that co-invests through its own investment vehicle may not qualify for the Capital Interest Exception and therefore could be subject to the three-year holding period.

1 All “Section” references are to the Internal Revenue Code of 1986, as amended, or the Treasury Regulations promulgated thereunder.

© 2021 Foley & Lardner LLPNational Law Review, Volume XI, Number 172
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About this Author

Raj Tanden, Foley, development companies lawyer, closely held businesses attorney
Partner

Raj Tanden is a partner and business lawyer with Foley & Lardner LLP, where he represents clients in corporate and tax matters across a broad spectrum of domestic and cross-border transactions. Mr. Tanden chairs the firm’s Southern California Tax Practice. His practice includes assisting clients with investment management transactions, including the formation of and investments by public and private investment funds and investors. Mr. Tanden advises business development companies, closely held businesses, public and private investment funds and real estate investment...

213-972-4575
 Benjamin B. Genzer Associate Milwaukee Taxation Corporate Employee Benefits & Executive Compensation
Associate

Benjamin B. Genzer is an associate and business lawyer with Foley & Lardner LLP, and he is a member of the firm’s Taxation Practice.

Ben’s practice focuses on tax planning, tax-exempt and nonprofit organizations, executive compensation, and closely-held business planning.

414-319-7470
Ashley May, Foley Lardner Law Firm, Los Angeles, Tax Law Attorney
Associate

Ashley May is an associate and business lawyer with Foley & Lardner LLP, where she is a member of the firm’s Taxation Practice. Her practice focuses on the U.S. federal income tax consequences of mergers and acquisitions, financings, and investment management transactions.

Prior to joining Foley, Ms. May served as an associate in the Tax Department of a major law firm in New York. She also served as an extern to Judge Gary Allen Feess in the United States District Courts, as well as the United States Attorney’s Office, both for the Central...

213-972-4565
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