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As a result of final Treasury Regulations issued by the IRS under Section 1061,¹ 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.

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