Guidance Under Section 1061, 5452-5494 [2021-00427]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 86, Number 11 (Tuesday, January 19, 2021)]
[Rules and Regulations]
[Pages 5452-5494]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2021-00427]



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Vol. 86

Tuesday,

No. 11

January 19, 2021

Part III

Book 2 of 2 Books

Pages 5451-6242





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Guidance Under Section 1061; Final Rule

Federal Register / Vol. 86, No. 11 / Tuesday, January 19, 2021 / 
Rules and Regulations

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9945]
RIN 1545-BO81


Guidance Under Section 1061

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations that provide guidance 
under section 1061 of the Internal Revenue Code (Code). Section 1061 
recharacterizes certain net long-term capital gains of a partner that 
holds one or more applicable partnership interests as short-term 
capital gains. An applicable partnership interest is an interest in a 
partnership that is transferred to or held by a taxpayer, directly or 
indirectly, in connection with the performance of substantial services 
by the taxpayer, or any other related person, in any applicable trade 
or business. These final regulations also amend existing regulations on 
holding periods to clarify the holding period of a partner's interest 
in a partnership that includes in whole or in part an applicable 
partnership interest and/or a profits interest. These regulations 
affect taxpayers who directly or indirectly hold applicable partnership 
interests in partnerships and the passthrough entities through which 
the applicable partnership interest is held.

DATES: 
    Effective date: These regulations are effective on January 13, 
2021.
    Applicability date: For dates of applicability, see Sec. Sec.  
1.702-1(g), 1.704-3(f), 1.1061-1(b), 1.1061-2(c), 1.1061-3(f), 1.1061-
4(d), 1.1061-5(g), 1.1061-6(e), and 1.1223-3(g).

FOR FURTHER INFORMATION CONTACT: Kara K. Altman or Sonia K. Kothari at 
(202) 317-6850 or Wendy L. Kribell at (202) 317-5279 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains final regulations under section 1061 of the 
Code to amend the Income Tax Regulations (26 CFR part 1). Section 1061 
was added to the Code on December 22, 2017, by section 13309 of Public 
Law 115-97, 131 Stat. 2054 (2017), commonly referred to as the Tax Cuts 
and Jobs Act (TCJA). Section 1061 applies to taxable years beginning 
after December 31, 2017. Section 1061 recharacterizes certain net long-
term capital gain with respect to applicable partnership interests 
(APIs) as short-term capital gain.
    On August 14, 2020, the Department of the Treasury (Treasury 
Department) and the IRS published a notice of proposed rulemaking (REG-
107213-18) in the Federal Register (85 FR 49754) containing proposed 
regulations under sections 702, 704, 1061, and 1223 of the Code 
(proposed regulations). The Treasury Department and the IRS received 
written and electronic comments responding to the proposed regulations. 
No public hearing was requested or held. All comments are available at 
www.regulations.gov or upon request. After full consideration of all 
comments timely received, this Treasury decision adopts the proposed 
regulations with modifications in response to the comments as described 
in the Summary of Comments and Explanation of Revisions section of this 
preamble.

Summary of Comments and Explanation of Revisions

    Most of the comments addressing the proposed regulations are 
summarized in this Summary of Comments and Explanation of Revisions. 
However, non-substantive comments or comments merely summarizing or 
interpreting the proposed regulations, recommending statutory 
revisions, or addressing provisions outside the scope of these final 
regulations are not discussed in this preamble.
    The final regulations retain the structure of the proposed 
regulations, with certain revisions. Section 1.1061-1 provides 
definitions of the terms used in Sec. Sec.  1.1061-1 through 1.1061-6 
of these final regulations (Section 1061 Regulations or final 
regulations). Section 1.1061-2 provides rules and examples regarding 
APIs and applicable trades or businesses (ATBs). Section 1.1061-3 
provides guidance on the exceptions to the definition of an API, 
including the capital interest exception. Section 1.1061-4 provides 
guidance on the computation of the Recharacterization Amount and gives 
computation examples. Section 1.1061-5 provides guidance regarding the 
application of section 1061(d) to transfers to certain related parties. 
Section 1.1061-6 provides reporting rules. Because the application of 
section 1061 requires a clear determination of the holding period of a 
partnership interest that is, in whole or in part, an API, the final 
regulations also provide clarifying amendments to Sec.  1.1223-3. 
Additional clarifying amendments to Sec. Sec.  1.702-1(a)(2) and 1.704-
3(e) are also provided.
    Part I of this Summary of Comments and Explanation of Revisions 
provides an overview of the statutory provisions and defined terms used 
in the proposed and final regulations. Part II describes the comments 
received and revisions made in response to those comments with respect 
to the following four areas of the proposed regulations: (1) The 
capital interest exception; (2) the treatment of capital interests 
acquired with loan proceeds; (3) the Lookthrough Rule for certain API 
dispositions; and (4) transfers of APIs to Section 1061(d) Related 
Persons. Part III discusses additional comments received and revisions 
made in other areas of the proposed regulations. Part IV summarizes 
comments received on issues related to section 1061 that are beyond the 
scope of the regulations and are under study. Part V discusses 
applicability dates for the final regulations. In addition to the 
revisions made in response to comments, clarifying changes have been 
made throughout the final regulations.

I. Overview and Defined Terms

A. Section 1061(a): Recharacterization Amount, Owner Taxpayer, and 
Related Concepts

1. Recharacterization Amount
    Section 1061(a) recharacterizes as short-term capital gain the 
difference between a taxpayer's net long-term capital gain with respect 
to one or more APIs and the taxpayer's net long-term capital gain with 
respect to these APIs if paragraphs (3) and (4) of section 1222, which 
define the terms long-term capital gain and long-term capital loss, 
respectively, for purposes of subtitle A of the Code, are applied using 
a three-year holding period instead of a one-year holding period. The 
regulations refer to this difference as the Recharacterization Amount. 
This recharacterization is made regardless of any election in effect 
under section 83(b).
2. Owner Taxpayers and Passthrough Entities
    The regulations provide that the person who is subject to Federal 
income tax on the Recharacterization Amount is required to calculate 
such amounts and refer to this person as the Owner Taxpayer. Although 
an API can be held directly by an Owner Taxpayer, it also may be held 
indirectly through one or more passthrough entities (Passthrough 
Entities). A Passthrough Entity may be a partnership, trust, estate, S 
corporation, or a passive foreign investment company (PFIC) with 
respect to which the shareholder has a

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qualified electing fund (QEF) election in effect. An API Holder is any 
person who holds an API. The regulations provide a framework for 
determining the Recharacterization Amount when an API is held through 
one or more tiers of Passthrough Entities (tiered structure).
3. Gains and Losses Subject to Section 1061
    Section 1061(a) applies to a taxpayer's net long-term capital gain 
with respect to one or more APIs held during the taxable year. The 
regulations provide that the determination of a taxpayer's net long-
term capital gain with respect to the taxpayer's APIs held during the 
taxable year includes the taxpayer's combined net distributive share of 
long-term capital gain or loss from all APIs held during the taxable 
year and the Owner Taxpayer's long-term capital gain and loss from the 
disposition of any APIs during the taxable year. The regulations 
generally refer to long-term capital gains and losses recognized with 
respect to an API as API Gains and Losses. However, API Gains and 
Losses do not include long-term capital gain determined under sections 
1231 and 1256, qualified dividends described in section 1(h)(11)(B), 
and any other capital gain that is characterized as long-term or short-
term without regard to the holding period rules in section 1222, such 
as capital gain characterized under the identified mixed straddle rules 
described in section 1092(b).
    Unrealized API Gains and Losses means, with respect to a 
Passthrough Entity's assets, all unrealized capital gains and losses 
that would be realized if those assets were disposed of for fair market 
value in a taxable transaction and allocated to an API Holder with 
respect to its API, taking into account the principles of section 
704(c). In a tiered structure, API Gains and Losses and Unrealized API 
Gains and Losses retain their character as API Gains and Losses as they 
are allocated through the tiers.

B. Section 1061(c)(1): Definition of an Applicable Partnership Interest

    Section 1061(c)(1) provides that an API is 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 ATB. For this purpose, 
the regulations define a Related Person as a person or entity who is 
treated as related to another person or entity under section 707(b) or 
267(b). Both section 1061(c)(1) and the regulations provide that an API 
does not include certain partnership interests held by employees of 
entities that are not engaged in an ATB.
    The regulations provide that an API means any interest in a 
partnership which, directly or indirectly, is transferred to (or is 
held by) an Owner Taxpayer or Passthrough Taxpayer in connection with 
the performance of substantial services by the Owner Taxpayer or by a 
Passthrough Taxpayer, or by a Related Person, including services 
performed as an employee, in any ATB unless an exception applies. There 
may be one or more Passthrough Entities between the partnership that 
originally issued the API and the Passthrough Entity in which the Owner 
Taxpayer holds its indirect interest in the API. Each Passthrough 
Entity in the tiered structure is treated as holding an API under the 
regulations, that is, each Passthrough Entity is an API Holder as is 
the Owner Taxpayer. An API Holder may be an individual, partnership, 
trust, estate, S corporation (as defined in section 1361(a)(1)), or a 
PFIC with respect to which the shareholder has a QEF election in effect 
under section 1295.
    Section 1061(c)(1), similar to section 1061(a), uses the term 
``taxpayer.'' The proposed regulations provide that an Owner Taxpayer 
is the taxpayer for purposes of section 1061(a). The regulations 
further provide that the reference to ``taxpayer'' in section 
1061(c)(1) also includes a Passthrough Taxpayer. A Passthrough Taxpayer 
is a Passthrough Entity that is treated as a taxpayer for the purpose 
of determining the existence of an API, regardless of whether such 
Passthrough Taxpayer itself is subject to Federal income tax. 
Generally, if an interest in a partnership is transferred to a 
Passthrough Taxpayer in connection with the performance of its own 
services, the services of its owners, or the services of persons 
related to either such Passthrough Taxpayer or its owners, the interest 
is an API as to the Passthrough Taxpayer. The Passthrough Taxpayer's 
ultimate owners will be treated as Owner Taxpayers, unless otherwise 
excepted.
    A partnership interest is an API if it was transferred in 
connection with the performance of substantial services. The 
regulations presume that services are substantial with respect to a 
partnership interest transferred in connection with services. This 
presumption is based on the assumption, for purposes of section 1061, 
that the parties have economically equated the services performed or to 
be performed with the potential value of the partnership interest 
transferred. The regulations provide that, subject to certain 
exceptions, once a partnership interest is an API, it remains an API 
and never loses its API character.

C. Section 1061(c)(2): Definition of an Applicable Trade or Business

    Under section 1061, for an interest in a partnership to be an API, 
the interest must be held or transferred in connection with the 
performance of substantial services in an ATB. An ATB is defined in 
section 1061(c)(2) as any activity conducted on a regular, continuous, 
and substantial basis consisting, in whole or in part, of raising or 
returning capital, and either (i) investing in (or disposing of) 
specified assets (or identifying specified assets for such investing or 
disposition), or (ii) developing specified assets. The regulations 
refer to these actions, respectively, as Raising or Returning Capital 
Actions and Investing or Developing Actions (collectively, Specified 
Actions). The regulations provide that an activity is conducted on a 
regular, continuous, and substantial basis if it meets the ATB Activity 
Test. The ATB Activity Test is met if the total level of activity 
(conducted in one or more entities) meets the level of activity 
required to establish a trade or business for purposes of section 162.
    In applying the ATB Activity Test, the regulations provide that it 
is not necessary for both Raising or Returning Capital Actions and 
Investing or Developing Actions to occur in a single taxable year. In 
that regard, the combined Specified Actions are considered together to 
determine if the ATB Activity Test is met.
    Section 1061(c)(3) provides that specified assets (Specified 
Assets) are securities, as defined in section 475(c)(2) (without regard 
to the last sentence thereof), commodities, as defined in section 
475(e)(2), real estate held for rental or investment, cash or cash 
equivalents, options or derivative contracts with respect to any of the 
foregoing, and an interest in a partnership to the extent of the 
partnership's proportionate interest in any of the foregoing. The 
definition of Specified Assets in the regulations generally tracks the 
statutory language. It also includes an option or derivative contract 
on a partnership interest to the extent that the partnership interest 
represents an interest in other Specified Assets.

D. Section 1061(c)(4) and Other Exceptions to API Treatment

    Section 1061 includes four exceptions to the treatment of a profits 
interest as an API and the regulations add an additional exception.

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    First, the statutory definition of an API in section 1061(c)(1) 
excludes an interest held by a person who is employed by another entity 
that is conducting a trade or business (other than an ATB) and provides 
services only to such other entity.
    Second, section 1061(c)(4)(A) provides that an API does not include 
any interest in a partnership directly or indirectly held by a 
corporation. The regulations provide that the term ``corporation'' for 
purposes of section 1061(c)(4)(A) does not include an S corporation for 
which an election under section 1362(a) is in effect or a PFIC with 
respect to which the shareholder has a QEF election under section 1295 
in effect.
    Third, section 1061(c)(4)(B) provides that an API does not include 
a capital interest which provides a right to share in partnership 
capital commensurate with (i) the amount of capital contributed 
(determined at the time of receipt of such partnership interest), or 
(ii) the value of such interest subject to tax under section 83 upon 
the receipt or vesting of such interest (the capital interest 
exception). The regulations provide that long-term capital gains and 
losses with respect to an API Holder's capital investment in a 
Passthrough Entity, referred to as Capital Interest Gains and Losses 
(which can include allocations and disposition amounts meeting the 
requirements), are not subject to recharacterization under section 
1061. As explained in more detail in Part II.A. of this Summary of 
Comments and Explanation of Revisions, to meet this exception to API 
treatment, the proposed regulations require allocations to API Holders 
(or Passthrough Entities that hold an API in a lower-tier Passthrough 
Entity) to be made in the same manner as to certain other partners. The 
final regulations provide a revised and simplified rule that looks to 
whether allocations are commensurate with capital contributed.
    Fourth, section 1061(b) provides that to the extent provided by the 
Secretary, section 1061 will not apply to income or gain attributable 
to any asset not held for portfolio investment on behalf of third party 
investors.
    Finally, the regulations provide that an interest in a partnership 
that was an API in the hands of the seller will not be treated as an 
API in the hands of the purchaser if the interest is acquired by a bona 
fide purchaser who (i) does not provide services in the Relevant ATB to 
which the acquired interest relates, (ii) is unrelated to any service 
provider, and (iii) acquired the interest for fair market value.

E. Section 1061(d): Transfer of API to a Section 1061(d) Related Person

    Section 1061(d)(1) provides that if a taxpayer transfers an API, 
directly or indirectly, to a related person described in section 
1061(d)(2), the taxpayer must include in gross income (as short term 
capital gain) the excess of so much of the taxpayer's long term capital 
gains with respect to such interest for the taxable year attributable 
to the sale or exchange of any asset held for not more than 3 years as 
is allocable to such interest over any amount treated as short term 
capital gain under section 1061(a).
    A related person for purposes of section 1061(d)(2) (a Section 
1061(d) Related Person) is defined more narrowly than a related person 
for purposes of section 1061(c)(1) and includes only members of the 
taxpayer's family within the meaning of section 318(a)(1), the 
taxpayer's colleagues (those who provided services in the ATB during 
certain time periods) and, under the regulations, a Passthrough Entity 
to the extent that a member of the taxpayer's family or a colleague is 
an owner.

F. Section 1061(e): Reporting

    Section 1061(e) provides that the Secretary ``shall require such 
reporting (at the time and in the manner prescribed by the Secretary) 
as is necessary to carry out the purposes of [section 1061].'' The 
regulations set forth the reporting requirements and include rules for 
providing information required to compute the Recharacterization Amount 
when there is a tiered structure.

G. Regulatory Authority

    Section 1061(f) provides that the Secretary ``shall issue such 
regulations or other guidance as is necessary or appropriate to carry 
out the purposes of [section 1061].'' The legislative history indicates 
that such guidance is to address the prevention of abuse of the 
purposes of the provision. See H.R. Conf. Rep. No. 115-466 at 422 
(2017) (Conference Report); see also Joint Committee on Taxation, 
General Explanation of Public Law 115-97, JCS-1-18, at 203 (2017) (Blue 
Book). The Conference Report and the Blue Book also state that the 
guidance is to address the application of the provision to tiered 
structures of entities. See id.

II. Primary Changes to the Proposed Regulations

    The majority of comments received on the proposed regulations 
relate to four areas: (1) The capital interest exception; (2) the 
treatment of capital interests acquired with loan proceeds; (3) the 
Lookthrough Rule for certain API dispositions; and (4) transfers of 
APIs to Section 1061(d) Related Persons. After considering these 
comments, the Treasury Department and the IRS have determined that 
changes in approach are required for each of these sections of the 
final regulations. The remainder of this section generally describes 
the comments received in these areas and the changes made in response. 
While all comments timely received were considered, comments are not 
described in detail to the extent that the ancillary concerns raised by 
the commenter were resolved by the changes made to the final 
regulations.

A. Capital Interest Exception

    Section 1061(c)(4)(B) provides that an API does not include certain 
capital interests. The proposed regulations implement the capital 
interest exception by excepting from recharacterization long-term 
capital gains and losses that represent a return on an API Holder's 
capital invested in a Passthrough Entity. The proposed regulations 
refer to these amounts as Capital Interest Gains and Losses, and 
include in that definition Capital Interest Allocations, Passthrough 
Interest Capital Allocations, and Capital Interest Disposition Amounts 
that meet the requirements of proposed Sec.  1.1061-3(c)(3) through 
(6).
    The majority of comments received regarding the capital interest 
exception suggested that the rules in the proposed regulations are too 
rigid and do not reflect many common business arrangements, resulting 
in many capital interest holders being denied eligibility for the 
exception. Commenters described a variety of concerns, detailed in this 
Part II.A.
    The final regulations provide a revised and simplified rule that 
looks to whether allocations are commensurate with capital contributed. 
An allocation will be considered a Capital Interest Allocation if the 
allocation to the API Holder with respect to its capital interest is 
determined and calculated in a similar manner to the allocations with 
respect to capital interests held by similarly situated Unrelated Non-
Service Partners who have made significant aggregate capital 
contributions.
1. Capital Interest Allocations, in General
    Proposed Sec.  1.1061-3(c)(3) provides that for an allocation to be 
treated as a Capital Interest Allocation or a Passthrough Interest 
Capital Allocation, the allocation must be one made in the

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same manner to all partners. As described further in part II.A.2. of 
this Summary of Comments and Explanation of Provisions, proposed Sec.  
1.1061-3(c)(4) further provides, in part, that Capital Interest 
Allocations are allocations of long-term capital gain or loss make to 
an API Holder and to Unrelated Non-Service Partners based on their 
respective capital account balances where the Unrelated Non-Service 
Partners have a significant aggregate capital account balance equal to 
five percent or more of the aggregate capital account balance of the 
partnership are the time the allocations are made. The proposed 
regulations also indicate that in general, an allocation will be deemed 
to satisfy the ``same manner'' requirement if, under the partnership 
agreement, the allocation is based on the relative capital accounts of 
the partners (or Passthrough Entity owners) who are receiving the 
allocation in question and the terms, priority, type and level of risk, 
rate of return, and rights to cash or property distributions during the 
partnership's operations and on liquidation are the same. Allocations 
to an API Holder may be subordinated to allocations to Unrelated Non-
Service Partners or reduced by the cost of services provided by such 
API Holder or a Related Person. Under proposed Sec.  1.1061-
3(c)(3)(ii), in the case of a partnership that maintains capital 
accounts under Sec.  1.704-1(b)(2)(iv), the allocation must be tested 
based on that partner's capital account. In the case of a Passthrough 
Entity that is not a partnership (or a partnership that does not 
maintain capital accounts under Sec.  1.704-1(b)(2)(iv)), if the 
Passthrough Entity maintains and determines accounts for its owners 
using principles similar to those provided under Sec.  1.704-
1(b)(2)(iv), those accounts will be treated as a capital account for 
purposes of the proposed regulations.
    Several commenters noted that requiring allocations be made in 
accordance with partners' overall section 704(b) capital accounts in a 
fund does not comport with the commercial reality of how most venture 
capital, private equity funds, and hedge funds make their allocations, 
and would preclude API Holders from ever utilizing the capital interest 
exception. One commenter noted that many bona fide partnerships use 
targeted allocations and questioned whether it is fair to exclude 
partnerships that do not maintain section 704(b) capital or similar 
accounts from the capital interest exception when those capital 
accounts lack economic significance in the business arrangement. The 
commenter asked the same question about partnerships that maintain 
capital accounts using generally accepted accounting principles (GAAP).
    Several commenters objected to the ``same manner'' requirement on 
the grounds that it did not properly implement section 1061(c)(4)(B), 
which provides, in part, that an API ``shall not include any capital 
interest in the partnership which provides the taxpayer with a right to 
share in partnership capital commensurate with . . . the amount of 
capital contributed'' by such partner. Commenters explained that while 
fund managers may earn an economic return on both their capital 
investment and their APIs, they generally do not have the same economic 
rights with respect to their capital investment that the limited 
partners in the fund have with respect to their capital investment. For 
example, commenters indicated that an API Holder may be entitled to tax 
distributions, may have different allocations of expenses, may be 
subject to regulatory allocations (for example, minimum gain 
chargeback, as described in Sec.  1.704-2), and may have different 
withdrawal or liquidity rights, which might be more or less favorable 
than those provided to Unrelated Non-Service Partners. Commenters 
indicated there could be varying liquidity rights between Unrelated 
Non-Service Partners and noted that API Holders' capital may be subject 
to more risk than Unrelated Non-Service Partners' capital in that API 
Holders may bear the first risk of loss. In the case of hedge funds, 
commenters noted that limited partners may invest at different times 
and, as such, earn a return that may not be comparable to other limited 
partners' returns.
    In addition, several commenters explained that economic rights and 
allocations in private equity and venture capital funds are frequently 
determined and made on a deal-by-deal basis, including allocations made 
in a tiered structure by an API Holder that is a Passthrough Entity, 
and that funds may have multiple classes of interests with different 
rights and obligations, meaning that economic rights and allocations 
are rarely, if ever, aligned with respect to all partners based on the 
partners' section 704(b) capital accounts.
    For the aforementioned reasons, several commenters recommended that 
the ``same manner'' requirement be eliminated and replaced with a rule 
that permits distributions and allocations to an API Holder, who 
contributes capital to a fund, to be ``commensurate'' with capital 
contributed by Unrelated Non-Service partners. Similarly, one commenter 
suggested that the only requirement be that an allocation to an API 
Holder be calculated and determined in a similar manner as the 
allocations to similarly situated Unrelated Non-Service Partners. 
Several commenters suggested that funds should be able to establish 
that they satisfied the ``commensurate'' standard using any reasonable 
method.
    Commenters also recommended that the scope of the term ``cost of 
services'' as used in the proposed regulations be further explained, 
noting that situations where API Holders' capital investments are not 
subject to management fees, while other investors' interests are 
subject to management fees, should not prevent the API Holders' capital 
interests from qualifying for the capital interest exception. 
Commenters recommended that the final regulations clarify the meaning 
of the term ``cost of services'' and specify that an API Holder's 
capital investment that is not subject to incentive payments or to 
management fees may still be eligible for the capital interest 
exception.
    Because private equity and hedge funds operate differently, 
commenters suggested that there should be separate rules, tailored to 
each structure, with respect to the capital interest exception. The 
commenters alluded to the notion that, although private equity and 
hedge funds each operate within a certain blueprint, there are many 
variations.
    The Treasury Department and the IRS generally agree with commenters 
that under the test in the proposed regulations, it might be difficult 
for some common business arrangements to meet the capital interest 
exception and that a partner comparison, based on capital contributed 
rather than the partners' section 704(b) capital accounts, would be 
more accurate in determining whether an interest qualifies for the 
capital interest exception. Accordingly, the final regulations provide 
that Capital Interest Allocations must be commensurate with capital 
contributed in order to qualify for the capital interest exception. The 
final regulations replace the requirement that allocations be made to 
all partners in the same manner with a requirement that an allocation 
to an API Holder with respect to its capital interest must be 
determined and calculated in a similar manner as the allocations with 
respect to capital interests held by similarly situated Unrelated Non-
Service Partners who have made significant aggregate capital 
contributions. In this regard, the allocations and distribution rights 
with respect to API Holders' capital interests and the capital 
interests of Unrelated Non-Service Partners who have made

[[Page 5456]]

significant aggregate capital contributions must be reasonably 
consistent. The similar manner test may be applied on an investment-by-
investment basis or on the basis of allocations made to a particular 
class of interests. The final regulations retain the factors used in 
the proposed regulations to determine whether allocations and 
distribution rights are made in a similar manner among partners: The 
amount and timing of capital contributed, the rate of return on capital 
contributed, the terms, priority, the type and level of risk associated 
with capital contributed, and the rights to cash or property 
distributions during the partnership's operations and on liquidation. 
The final regulations maintain the rule that an allocation to an API 
Holder will not fail to qualify solely because the allocation is 
subordinated to allocations made to Unrelated Non-Service Partners or 
because an allocation to an API Holder is not reduced by the cost of 
services provided by the API Holder or a Related Person to the 
partnership. The final regulations also clarify the meaning of cost of 
services for this purpose. The fact that API Holders are not charged 
management fees on their capital or that their capital is not subject 
to allocations of API items will not prevent the API Holder's capital 
interest from being eligible for the capital interest exception. 
Similarly, an allocation to an API Holder will not fail if an API 
Holder has a right to receive tax distributions while Unrelated Non-
Service Partners do not have such a right, where such distributions are 
treated as advances against future distributions.
    The final regulations extend these concepts to allocations made 
through tiered structures. The final regulations remove the terms 
Passthrough Capital Allocation, Passthrough Interest Capital 
Allocation, and Passthrough Interest Direct Investment Allocation, and 
instead provide that an allocation made to a Passthrough Entity that 
holds an API in a lower-tier Passthrough Entity will be considered a 
Capital Interest Allocation if made in accordance with the principles 
applicable in determining Capital Interest Allocations. Under the final 
regulations, Capital Interest Allocations retain their character when 
allocated to an upper-tier partnership so long as they are allocated 
among the partners in the upper-tier partnership with respect to such 
partners' capital interests in a manner that is respected under section 
704(b) (taking the principles of section 704(c) into account).
    Because the revised rules provide sufficient flexibility for all 
structures, the final regulations do not adopt the suggestion to 
provide a separate set of rules for private equity and hedge funds. The 
Treasury Department and the IRS continue to study other issues raised 
by the commenters, including the application of the similar manner 
requirement to S corporations and the application of the capital 
interest exception to co-invest vehicles.
    The Treasury Department and the IRS request any additional comments 
on the application of the capital interest exception in the final 
regulations.
2. Unrelated Non-Service Partner Requirement
    As discussed in the prior section, proposed Sec.  1.1061-3(c)(4) 
provides additional guidance on Capital Interest Allocations. Under the 
proposed regulations, Capital Interest Allocations are allocations of 
long-term capital gain or loss made under the partnership agreement to 
an API Holder and to Unrelated Non-Service Partners based on their 
respective capital accounts and which meet other requirements. 
Unrelated Non-Service Partners are defined in proposed Sec.  1.1061-
1(a) as partners who have not provided services to the Relevant ATB and 
who are not, and have never been, related to any API Holder in the 
partnership or any person who provides, or has provided, services in 
the Relevant ATB. Proposed Sec.  1.1061-3(c)(4) specifies that Capital 
Interest Allocations must be made in the same manner to API Holders and 
to Unrelated Non-Service Partners with a significant aggregate capital 
account balance (defined as five percent or more of the aggregate 
capital account balance of the partnership at the time the allocations 
are made). Proposed Sec.  1.1061-3(c)(4)(iii) provides that the 
allocations to the API Holder and the Unrelated Non-Service Partners 
must be clearly identified both under the partnership agreement and on 
the partnership's books and records as separate and apart from 
allocations made to the API Holder with respect to its API. The 
partnership agreement and the partnership books and records must also 
clearly demonstrate that the requirements for an allocation to be 
considered a Capital Interest Allocation have been met.
    For allocations made on a deal-by-deal or class-by-class basis, 
commenters noted that it is unclear if the requirement that allocations 
be made in the same manner to API Holders and Unrelated Non-Service 
Partners with a significant aggregate capital account balance applies 
to each deal or class, or if it applies only to a fund generally. One 
commenter suggested that as an alternative to a strict percentage test, 
funds should also be able to satisfy the test by establishing that the 
return on a class of equity was determined at arm's length. Another 
commenter noted that a specific number or percentage of Unrelated Non-
Service Partners must comprise the test group to prevent easy avoidance 
of the statute but questioned whether the five percent threshold for 
the test group is the appropriate threshold. The commenter also asked 
for clarification on the effect of the rule in proposed Sec.  1.1061-
3(c)(3)(ii)(C) that a capital account, for these purposes, does not 
include the contribution of amounts attributable to loans made by other 
partners or the partnership when comparing the allocations made to API 
Holders and Unrelated Non-Service Partners.
    One commenter stated that many funds would be unable to meet the 
requirement that allocations to the API Holder and the Unrelated Non-
Service Partners be clearly identified in the partnership agreement 
because their agreements use liquidating distributions to govern an API 
Holder's rights with respect to its API rather than allocations. The 
commenter recommended that the requirement be considered satisfied if 
the distribution provision clearly identified capital interest 
distributions separate and apart from distributions with respect to 
APIs. Several other commenters suggested that the rule requiring the 
allocations to be clearly identified both under the partnership 
agreement and on the partnership's books and records be disjunctive, 
that is, that the allocations be clearly demarcated in either the 
partnership agreement or on the partnership's books and records. 
Commenters noted that in order to meet the partnership agreement 
reporting requirement, a fund would have to update its partnership 
agreements, which could be done only by negotiating with the Unrelated 
Non-Service Partners. Initiating those negotiations could cause 
partners to want to negotiate other partnership items, which could take 
time and alter the agreements. These commenters thus suggested 
grandfathering existing partnership agreements or providing a 
transition period for funds to update their agreements to comply with 
this requirement.
    The final regulations retain the requirement that Capital Interest 
Allocations to an API Holder be compared to Capital Interest 
Allocations made to Unrelated Non-Service Partners, as well as the 
requirement that Capital Interest Allocations be made to Unrelated Non-
Service Partners with a significant capital account balance,

[[Page 5457]]

including the five percent threshold. The Treasury Department and the 
IRS considered a number of alternatives and determined that the five 
percent threshold adequately insures that there is a significant 
comparison to meet the statutory exception that an API does not include 
a capital interest which provides the API Holder with a right to share 
in partnership capital commensurate with the amount of capital 
contributed. In accordance with the provision that the similar manner 
test in the final regulations may be applied on an investment-by-
investment or class-by-class basis, the final regulations specify that 
the Unrelated Non-Service Partner requirement can also be applied on an 
investment-by-investment basis, or on a class-by-class basis. The final 
regulations move the definition of Capital Interest Allocations to the 
definition section of the final regulations but retain the requirement 
that allocations with respect to, and corresponding to, contributed 
capital be clearly identified under both the partnership agreement and 
in the partnership's books and records as separate and apart from 
allocations made to the API Holder with respect to its API, and specify 
that the books and records must be contemporaneous. Documenting the 
allocations in the partnership agreement and in contemporaneous books 
and records is a necessary corollary to the rule requiring Capital 
Interest Allocations to be made in a similar manner between API Holders 
and Unrelated Non-Service Partners with a significant interest, because 
it shows that the partnership's Unrelated Non-Service Partners 
considered these allocations a valid return on their contributed 
capital.
    The final regulations do not include a rule that would grandfather 
existing partnership agreements or provide a transition period for 
partnerships to update their agreements. Because the final regulations 
more closely align the capital interest exception to standard industry 
practice, the number of partnership agreements that will need to be 
amended is reduced. Allocations made to an API Holder that do not meet 
the requirements of these final regulations will not be considered 
Capital Interest Allocations. Finally, due to the revisions made to the 
capital interest exception in these final regulations, the Treasury and 
the IRS have determined that it is not necessary to clarify the effect 
that the rule disregarding contributions made with the proceeds of 
loans by other partners or by the partnership has on the comparison of 
the allocation made to API Holders and Unrelated Non-Service Partners.
3. Capital Interest Disposition Amounts
    If an owner disposes of an interest in a Passthrough Entity that is 
composed of a capital interest and an API, proposed Sec.  1.1061-
3(c)(6) provides a mechanism for the owner to determine the portion of 
long-term capital gain or loss recognized on the disposition that is 
treated as a Capital Interest Disposition Amount and thus, a Capital 
Interest Gain or Loss.
    The final regulations clarify the determination of an API Holder's 
Capital Interest Disposition Amount when the API Holder transfers a 
Passthrough Entity interest that is comprised of both an API and a 
capital interest at a gain and would be allocated only capital loss as 
a Capital Interest Allocation if all of the assets of the Passthrough 
Entity had been sold for their fair market value in a fully taxable 
transaction immediately before the interest transfer. In such an 
instance, the final regulations provide that all of the long-term 
capital gain attributable to the interest transfer is API Gain. 
Conversely, if such API Holder recognizes long-term capital loss on the 
transfer of a Passthrough Entity interest and would be allocated only 
capital gain as a Capital Interest Allocation if all of the assets of 
the Passthrough Entity had been sold for their fair market value in a 
fully taxable transaction immediately before the interest transfer, the 
final regulations provide that all of the long-term capital loss 
attributable to the interest transfer is API Loss. The final 
regulations provide additional rules where a transferred Passthrough 
Entity interest results in a gain and the transferor would have been 
allocated both Capital Interest Gain and API Gain as well as where a 
transferred Passthrough Entity interest results in a loss and the 
transferor would have been allocated both Capital Interest Loss and API 
Loss. In such instances, a fraction is used to determine the portion of 
the transferred interest gain or loss characterized as a Capital 
Interest Disposition Amount.
    Commenters noted a concern that Example 5 in proposed regulation 
Sec.  1.1061-3(c)(7)(v), did not adequately address basis proration 
upon a partial interest sale where a partner holds a partnership 
interest comprised of both an API and a capital interest. Specifically, 
one commenter noted that Example 5's reliance on the equitable 
apportionment approach of Sec.  1.61-6(a) could lead to a situation 
where the characterization of the gain or loss attributable to the sale 
of a portion of the partner's partnership interest differs from the 
characterization of that partner's distributive share of asset gain or 
loss if all of the assets of the Passthrough Entity were sold for their 
fair market value in a fully taxable transaction. Another commenter 
suggested applying the specific identification rules in Sec.  1.1223-3 
applicable to publicly traded partnership units to transfers of private 
interests. These commenters noted that because the issue illustrated in 
Example 5 has ramifications beyond section 1061, further study should 
occur before proceeding with the position stated in Example 5.
    The Treasury Department and the IRS continue to study the issue 
noted with respect to Example 5 and have removed the example in the 
interim as many of the concerns raised on the sale of a partial 
partnership interest extend beyond section 1061.
4. Unrealized API Gains and Losses
    Proposed Sec.  1.1061-1(a) defines Unrealized API Gains and Losses 
as all unrealized capital gains and losses, including both short-term 
and long-term, that would be allocated to an API Holder with respect to 
its API if all relevant assets were disposed of for fair market value 
in a taxable transaction on the relevant date. Proposed Sec.  1.1061-
2(a)(1)(ii) provides rules for the treatment of Unrealized API Gains 
and Losses, including the requirement to determine Unrealized API Gains 
and Losses in tiered structures. Proposed Sec.  1.1061-3(c)(3)(iii) 
provides that Capital Interest Allocations and Passthrough Interest 
Capital Allocations do not include amounts treated as API Gains and 
Losses or Unrealized API Gains and Losses.
    A commenter stated that the requirement to determine Unrealized API 
Gains and Losses in tiered structures is not reasonable because an 
upper-tier Passthrough Entity would not be able to require every 
uncontrolled lower-tier Passthrough Entity in the chain to revalue its 
assets under the principles of Sec.  1.704-1(b)(2)(iv)(f). The 
commenter recommended that the mandatory section 1061 revaluation rules 
be eliminated. The commenter requested instead that the existing rules 
for revaluations under the section 704(b) and 704(c) regulations govern 
Unrealized API Gains and Losses. Alternatively, the commenter suggested 
that anti-abuse regulations be written to address revaluations in 
chains of controlled tiered partnerships.
    The final regulations remove the mandatory revaluation rules and 
adopt the commenter's suggestion that

[[Page 5458]]

Unrealized API Gains and Losses be determined according to the existing 
rules governing unrealized gains and losses, including section 704(c) 
principles. Accordingly, the final regulations provide that the term 
Unrealized API Gains and Losses means, with respect to a Passthrough 
Entity's assets, all unrealized capital gains and losses that would be 
(i) realized if those assets were disposed of for fair market value in 
a taxable transaction on the relevant date, and (ii) allocated to an 
API Holder with respect to its API, taking into account the principles 
of section 704(c).
    Because the proposed regulations provide that Capital Interest 
Allocations are made based on partners' relative section 704(b) capital 
accounts, several commenters questioned whether Unrealized API Gains 
and Losses that are reflected in an API Holder's capital account could 
generate Capital Interest Allocations, including book Capital Interest 
Allocations, before these amounts are recognized. Commenters explained 
that these issues are particularly relevant for hedge funds and 
described their operations and incentive structure. When an API Holder 
in a hedge fund receives incentive allocations with respect to the API, 
its capital account is increased by the amount of the incentive 
allocation, and Unrelated Non-Service Partners' capital accounts are 
decreased. This increase is coupled with allocations of taxable income 
and gain and also allocations of unrealized gain (reverse section 
704(c) allocations). Commenters also requested additional guidance on 
the treatment of realized and unrealized gains from an API which are 
contributed to, or reinvested in, a partnership.
    The final regulations continue to provide that Unrealized API Gains 
and Losses are not included in Capital Interest Gains and Losses. In 
response to comments, the final regulations clarify that if an API 
Holder is allocated API Gain by a Passthrough Entity, to the extent 
that an amount equal to the API Gain is reinvested in Passthrough 
Entity by the API Holder (either as the result of an actual 
distribution and recontribution of the API Gain amount or the retention 
of the API Gain amount by the Passthrough Entity), the amount will be 
treated as a contribution to the Passthrough Entity for a capital 
interest that may produce Capital Interest Allocations for the API 
Holder, provided such allocations otherwise meet the requirements to be 
a Capital Interest Allocation.

B. Capital Contributions Made With the Proceeds of Partnership or 
Partner Loans

    Proposed Sec.  1.1061-3(c)(3)(ii)(C) provides that for purposes of 
proposed Sec. Sec.  1.1061-1 through 1.1061-6, a capital account does 
not include the contribution of amounts directly or indirectly 
attributable to any loan or other advance made or guaranteed, directly 
or indirectly, by any other partner, the partnership, or a Related 
Person with respect to any other partner or the partnership. Repayments 
on the loan are included in capital accounts as those amounts are paid 
by the partner, provided that the loan is not repaid with the proceeds 
of another similarly sourced loan. Id.
    Several commenters criticized this treatment, suggesting that the 
exclusion of these amounts from the partner's capital account inhibits 
common and reasonable business practices, and creates barriers to entry 
for service partners, particularly those who are less represented based 
on age, gender, or race or do not have ready access to capital. One 
commenter noted that it is typical for fund managers to either extend 
loans to their employees, or to guarantee loans issued to such 
employees by third parties, so that employees may invest in the 
manager's own investment funds. Similarly, another commenter stated 
that the proposed regulations would introduce a substantial impediment 
to raising capital for commercial real estate investment by creating a 
disincentive for general partners to finance or support the financing 
of the participation of its employees in its commercial real estate 
investments. The commenter claimed that contributions made in this 
manner are a significant source of capital available for real estate 
investment and also an important factor in attracting third party 
capital because they create an alignment of interest between the 
limited partners and the general partner and its employees.
    Commenters noted that neither the statute nor the legislative 
history indicates that the use of loan proceeds to make a capital 
contribution precludes the interest from being included in a partner's 
capital account and contended that adding such a rule is not justified 
by the commensurate with capital statutory language of the capital 
interest exception. To the contrary, commenters argued that the authors 
of the TCJA were familiar with prior proposals regarding profits 
interests that contained exceptions for loaned capital and their 
decision not to include such an exception in section 1061 is an 
indication that the choice was intentional. Instead, one commenter 
maintained that Congress addressed any concerns through the rule that a 
service provider's rights with respect to its contributed capital must 
match the rights of other non-service partners with respect to their 
shares of contributed capital.
    Some commenters recognized that the exclusion from capital accounts 
of contributions attributable to partner or partnership loans is an 
attempt to control the perceived abuse of limited partners loaning the 
general partner of the partnership an amount of capital that entitles 
the general partner to a portion of the partnership's profits in order 
to avoid the application of section 1061 and fit within the capital 
interest exception. Commenters noted that section 1061(f) provides the 
Secretary with authority to issue guidance as is necessary or 
appropriate to carry out the purposes of section 1061 and that the 
legislative history indicates that such guidance is to address the 
prevention of abuse of the purposes of the provision.
    Other commenters, suggesting that the policy behind the capital 
interest exception is to ensure a partner has capital at risk to 
qualify for the exception, acknowledged that there are fact patterns in 
which a partner might be considered less at risk. One commenter pointed 
to the at-risk limitation on losses under section 465, noting that a 
service provider would not be considered at-risk with respect to 
contributed capital that is financed through a loan from another 
partner, even if the loan were fully recourse to the service provider. 
By contrast, a partner is considered at-risk when an investment is 
funded by a third-party loan for which the partner has personal 
liability. Another commenter noted that the proposed regulations' 
treatment of a capital interest funded through a loan from the issuing 
partnership is consistent with the treatment of partnership loans under 
other areas of Subchapter K. The commenter pointed out that the 
contribution of a partner's own promissory note generally does not 
increase the partner's basis in its partnership interest under section 
722. Similarly, pursuant to Sec.  1.704-1(b)(2)(iv)(d)(2), the 
partner's capital account will be increased with respect to the 
promissory note only when there is a taxable disposition of the note by 
the partnership or when the partner makes principal payments on such 
note, provided that the note is not readily tradable on an established 
securities market.
    Despite recognizing these concerns regarding abuse, commenters

[[Page 5459]]

maintained that the loan proceeds exclusion should be eliminated 
because general income tax principles, such as those in sections 83 and 
7872, are sufficient to determine whether a loan-financed arrangement 
should not qualify for the capital interest exception. Other commenters 
suggested that if limitations must be imposed, the rule should be 
narrowly tailored, recommending that only loans that are nonrecourse or 
lack substantial security be excluded from the capital interest 
exception. Commenters also suggested that guarantees should not be 
treated in the same manner as a loan, particularly in the context of a 
recourse loan or a loan from a third-party bank. Another commenter 
suggested that if the loan or guarantee operates under normal arms-
length standards, it should be eligible to support a capital 
contribution. Another commenter noted that the proposed regulations are 
silent on loans that are fully secured with partnership assets.
    The Treasury Department and the IRS remain concerned that capital 
contributions made with the proceeds of loans made or guaranteed by 
another partner, the partnership, or a Related Person with respect to 
such partner or partnership could lead to abuse of the capital interest 
exception. Therefore, the final regulations do not adopt the 
suggestions to remove the rule. However, the Treasury Department and 
the IRS agree with commenters that the potential for abuse is reduced 
when a loan or advance is made by another partner (or Related Person 
with respect to such other partner, other than the partnership) to an 
individual service provider if the individual service provider is 
personally liable for the repayment of such loan or advance. 
Accordingly, the final regulations provide that an allocation will be 
treated as a Capital Interest Allocation if the allocation is 
attributable to a contribution made by an individual service provider 
that, directly or indirectly, results from, or is attributable to, a 
loan or advance from another partner in the partnership (or any Related 
Person with respect to such lending or advancing partner, other than 
the partnership) to such individual service provider if the individual 
service provider is personally liable for the repayment of such loan or 
advance as described in the final regulations. The final regulations 
apply a similar approach with respect to loans or advances made by a 
partner in the partnership (or a Related Person to such partner, other 
than the partnership) to a wholly owned entity that is disregarded as 
separate from an individual service provider where the individual 
service provider that owns such disregarded entity is personally liable 
for the repayment of any borrowed amounts that are not repaid by the 
disregarded entity. The final regulations provide that an individual 
service provider is personally liable for the repayment of a loan or 
advance made by a partner (or any Related Person, other than the 
partnership) if (i) the loan or advance is fully recourse to the 
individual service provider; (ii) the individual service provider has 
no right to reimbursement from any other person; and (iii) the loan or 
advance is not guaranteed by any other person. The Treasury Department 
and the IRS continue to study the treatment of guarantees generally in 
light of questions about who the borrower is for Federal tax purposes.
    A commenter noted that the proposed regulations' treatment of 
loans, together with the section 704(b) capital account approach being 
taken with respect to the capital interest exception, could mean that a 
partner who borrows from a related person to make even a small portion 
of his or her capital contribution might be denied the capital interest 
exception with respect to his or her entire capital interest. A few 
commenters recommended that if the treatment of related party loans is 
retained in the final regulations, adjustments should be made to ensure 
that partners are able to receive appropriate credit for capital 
contributions they make that are not attributable to loans. Another 
commenter stated that the proposed regulations did not provide a 
tracing regime to connect loan proceeds with capital contributions. One 
commenter suggested that final regulations clarify how to treat a 
partner that fully funded a capital contribution with loan proceeds but 
repaid such amounts before there was a capital interest allocation, 
including whether a revaluation would change the answer. The commenter 
recommended that it would be appropriate to treat the partner's capital 
account as funded at the time of actual contribution. Finally, the 
commenter recommended that final regulations include a transition rule 
related to related party loans made, advanced, guaranteed, or repaid 
before final regulations are issued. The Treasury Department and the 
IRS considered these comments and believe that the concerns raised in 
them are resolved by the commensurate with capital approach to the 
capital interest exception taken in the final regulations because this 
approach does not rely on a comparison of allocations based on the 
partners' overall section 704(b) capital accounts.

C. Lookthrough Rule for Certain API Dispositions

    Proposed Sec.  1.1061-4(b)(9) provides a limited Lookthrough Rule 
that may apply to the sale of an API where capital gain is recognized 
and the holding period of the API is more than three years. In the case 
of a disposition of a directly held API with a holding period of more 
than three years, the proposed Lookthrough Rule applies if the assets 
of the partnership in which the API is held meet the Substantially All 
Test. The Substantially All Test is met if 80 percent or more of the 
assets of the partnership in which the API is held, based on fair 
market value, are assets that would produce capital gain or loss that 
is not described in proposed Sec.  1.1061-4(b)(6) if disposed of by the 
partnership, and that have a holding period of three years or less. In 
the case of a tiered structure in which an API Holder holds its API 
through one or more Passthrough Entities, the Lookthrough Rule applies 
if the API Holder disposes of a Passthrough Interest held for more than 
three years and recognizes capital gain, and either: (i) The 
Passthrough Entity through which the API is directly or indirectly held 
has a holding period in the API that is three years or less, or (ii) 
the Passthrough Entity through which the API is held has a holding 
period in the API of more than three years and the assets of the 
partnership in which the API is held meet the Substantially All Test.
    The Treasury Department and the IRS received several comments 
stating that, although the application of the Lookthrough Rule for 
directly-held APIs is reasonable, the application of the Lookthrough 
Rule for indirectly-held APIs is punitive and imposes an unreasonable 
and significant administrative burden. The commenters recommended that 
the scope of the Lookthrough Rule for indirectly-held APIs be limited, 
particularly in the case of indirectly-held APIs where the relevant 
taxpayer does not control a partnership that issued the API. Another 
commenter questioned the authority for the Lookthrough Rule but noted 
that it is consistent with partnership tax principles and that the 
proposed regulation would be easily manipulated without the rule.
    Commenters suggested that the proposed regulations be amended in 
one or more of the following ways: (i) Limit the Lookthrough Rule to 
situations in which a Passthrough Entity controls all of the relevant 
lower-tier Passthrough

[[Page 5460]]

Entities (or only applying it to lower-tier Passthrough Entities that 
it controls); (ii) limit the Lookthrough Rule for indirectly held APIs 
to situations in which the API is held by a lower-tier Passthrough 
Entity for three years or less; (iii) limit the application of the 
Lookthrough Rule to situations in which assets that produce capital 
gain or loss of a type taken into account under section 1061 are a 
material amount (greater than 50 percent) of the value of the 
underlying assets of the partnership; (iv) eliminate the Substantially 
All Test in the context of tiered structures (that is, determine the 
applicability of the Substantially All Test with respect to the assets 
held by the partnership whose interest was sold); (v) amend the 
Substantially All Test so that a transferring taxpayer who has held its 
interest for more than three years will be required to look through to 
the underlying assets' character only if 80 percent or more of the 
assets held directly or indirectly by the Passthrough Entity have a 
holding period of three years or less; (vi) make information reporting 
related to the Lookthrough Rule mandatory for partnerships and S 
corporations and for required PFIC annual information statements 
regardless of whether a Passthrough Entity has issued or holds an API; 
(vii) provide a de minimis rule by which an upper-tier partnership 
holding a five percent or less interest in the lower-tier partnership 
would be allowed to use its holding period in the lower-tier 
partnership; and (viii) as a part of the de minimis rule, not require 
revaluations of lower-tier partnerships when an Owner Taxpayer disposes 
of an upper-tier interest that holds five percent or less of a lower-
tier partnership. A commenter recommended that the Lookthrough Rule 
approach calculations in tiered structures from the lower-tier entities 
up, aligning with the approach to tiered structures elsewhere in the 
proposed regulations, and allowing the rule to appropriately 
accommodate lower-tier gains from assets whose sale proceeds are 
treated as capital gains without regard to section 1222(3) and (4).
    After considering the comments, the Treasury Department and the IRS 
agree that the Lookthrough Rule as proposed could be difficult for 
Owner Taxpayers and Passthrough Entities to apply, particularly in the 
context of tiered structures. However, the Treasury Department and the 
IRS remain concerned that taxpayers could avoid section 1061 by 
transferring assets to, and issuing APIs from, existing partnerships. 
Accordingly, the final regulations retain the Lookthrough Rule, but 
instead of applying the Lookthrough Rule to the disposition of an API 
held for more than three years and where the Substantially All Test is 
met, the final regulations limit the application of the Lookthrough 
Rule to situations where, at the time of disposition of an API held for 
more than three years, (1) the API would have a holding period of three 
years or less if the holding period of such API were determined by not 
including any period prior to the date that an Unrelated Non-Service 
Partner is legally obligated to contribute substantial money or 
property directly or indirectly to the Passthrough Entity to which the 
API relates (this rule does not apply to the disposition of an API to 
the extent that the gain recognized upon the disposition of the API is 
attributable to any asset not held for portfolio investment on behalf 
of third party investors); or (2) a transaction or series of 
transactions has taken place with a principal purpose of avoiding 
potential gain recharacterization under section 1061(a). The 
Lookthrough Rule similarly applies with respect to a Passthrough 
Interest issued by an S corporation or a PFIC to the extent the 
Passthrough Interest is treated as an API. The final regulations also 
simplify the method for applying the Lookthrough Rule.
    Commenters also stated that the Lookthrough Rule raises a concern 
that going concern value in a lower-tier entity might be subject to 
ordinary income rates if an upper-tier partnership interest is sold, 
the Lookthrough Rule applies, and the upper-tier partnership owns a 
lower-tier partnership interest. These commenters recommended that gain 
associated with goodwill or enterprise value retain the holding period 
of the partnership interest itself, as opposed to the underlying 
assets, and that the Lookthrough Rule apply only to the gain associated 
with the hypothetical liquidation of the underlying assets. The 
Treasury Department and the IRS continue to study this issue and may 
address it in future guidance.
    One commenter requested clarification that the phrase ``total net 
capital gain'' in proposed Sec.  1.1061-4(b)(9)(ii)(C)(1) refers to 
``net long-term capital gain'' and that short- and long-term capital 
gains and losses cannot be netted against each other. The final 
regulations do not include this language. The Treasury Department and 
the IRS believe that the concerns raised by the commenter are 
alleviated by the simplified Lookthrough Rule adjustment in the final 
regulations.

D. Section 1.1061-5: Transfers to Related Parties

    Proposed Sec.  1.1061-5(a) provides that if an Owner Taxpayer 
transfers any API, or any Distributed API Property, directly or 
indirectly, to a Section 1061(d) Related Person, or if a Passthrough 
Entity in which an Owner Taxpayer holds an interest, directly or 
indirectly, transfers an API to a Section 1061(d) Related Person, 
regardless of whether gain is otherwise recognized on the transfer 
under the Code, the Owner Taxpayer must include in gross income as 
short-term capital gain, the excess of: (1) The Owner Taxpayer's net 
long-term capital gain with respect to such interest for such taxable 
year determined as provided in proposed Sec.  1.1061-5(c), over (2) any 
amount treated as short-term capital gain under proposed Sec.  1.1061-4 
with respect to the transfer of such interest (that is, any amount 
included in the Owner Taxpayer's API One Year Disposition Gain Amount 
and not in the Owner Taxpayer's Three Year Disposition Gain Amount with 
respect to the transferred interest). Proposed Sec.  1.1061-5(b) 
provides that for purposes of section 1061(d), the term transfer 
includes contributions, distributions, sales and exchanges, and gifts.
    Several commenters addressed whether section 1061(d) should be 
interpreted as an acceleration provision or merely a recharacterization 
provision. With certain exceptions, the proposed regulations require 
that gain be accelerated on the transfer of an API to a Section 1061(d) 
Related Person, regardless of whether the transfer is otherwise a 
taxable transaction for Federal income taxes or whether gain is 
otherwise realized or recognized under the Code on the transfer. One 
commenter supported this treatment, noting that section 1061(d)(1) is 
literally worded as an income acceleration provision while 
acknowledging that others have viewed the language as a 
recharacterization provision, such as section 751(a). Another commenter 
noted that neither the text nor the legislative history shed any light 
on its purpose and stated that the provision's language is susceptible 
to numerous different readings. The commenter noted that section 
1061(d) could be read as a narrow recharacterization lookthrough 
provision similar to section 751, a recharacterization and assignment 
of income provision that provides for nonrecognition transfers and 
requires the transferor rather than the transferee to include API Gain 
when ultimately realized, a recharacterization and acceleration 
provision, or a proration provision. The commenter did

[[Page 5461]]

not provide a recommendation, but noted that the proposed regulations 
create many traps for the unwary. The commenter stated that the broad 
definition of transfer in the proposed regulations combined with the 
overriding of nonrecognition treatment could lead to significant, 
adverse tax impacts on transferors as well as otherwise uninvolved, 
passive interest holders in a variety of transactions. The commenter 
suggested that the Treasury Department and the IRS carefully consider 
whether the effect of the proposed regulations is appropriate and 
aligns with section 1061(d)'s language, function, and origins.
    Other commenters argued that applying section 1061(d) to 
transactions where gain is not otherwise recognized is inconsistent 
with the statutory language. One commenter stated that section 1061(d) 
itself does not refer to any nonrecognition provisions, nor does it 
contain any express statement of intent to override nonrecognition 
treatment. This commenter and others noted that section 1061(d) 
operates by reference to the taxpayer's long-term capital gains, which 
as defined in section 1223(3) include only gains that are recognized 
for U.S. Federal income tax purposes. Consequently, these commenters 
argued that the statute by its terms does not apply to situations in 
which the taxpayer has no actual long-term capital gain with respect to 
such interest. Commenters also noted that the legislative history does 
not provide support for treating section 1061(d) as an acceleration 
provision. Previous carried interest provisions included language that 
explicitly overrode non-recognition; section 1061 as enacted contains 
no such language.
    One commenter stated that it is not necessary to accelerate gain on 
the transfer of an API to a Section 1061(d) Related Person, noting that 
the API in the hands of the transferee is still subject to section 
1061(a) because an API includes interests held by or transferred to the 
taxpayer in connection with the performance of a substantial service by 
the taxpayer or a related person.
    Commenters also raised a variety of concerns about the proposed 
regulation's definition of transfer. Commenters recommended that the 
term transfer be further defined to address potential cases involving 
indirect transfers of an API, such as the admission of new partners 
into the partnership, the withdrawal of old partners from the 
partnership, the transfer of an employee between teams, or an award to 
a high performer. One commenter explained that, in these circumstances, 
because there is no change in the relative economic position between 
fund managers and third-party investors, there should be no requirement 
for the fund manager or employees of the fund manager to recognize 
unrealized built-in gain. Commenters also recommended that the final 
regulations consider whether a forfeiture of an API is a transfer for 
purposes of section 1061(d) but stated that such an interpretation 
would be overbroad. One commenter noted that forfeiture and 
reallocations involve circumstances in which the partners' legal and 
economic interests in the partnership's Unrealized API Gains are 
contingent rather than fixed. Where a partner's interest in Unrealized 
API Gains is contingent, the commenter argued that it is not 
appropriate to tax a partner on a reduction in that interest under 
section 1061(d).
    Another commenter asked for clarification that the distribution of 
an API by a direct API Holder to an Owner Taxpayer (indirect API 
Holder) would be exempt from the application of section 1061(d). The 
commenter noted that section 1061(a) would continue to apply to the 
distributed API and that this treatment would be consistent with the 
rules related to Distributed API Property in Sec.  1.1061-4. Under 
those rules, a distribution of property by a Passthrough Entity to an 
API Holder is not subject to recharacterization under section 1061 but 
the Distributed API Property continues to be subject to section 1061. 
The commenter argued that this rule would also treat similarly situated 
taxpayers the same, rather than treating distributees of Distributed 
API Property differently from Owner Taxpayers who receive a 
distribution of an API from a partnership.
    Another commenter asked for clarification that the definition of 
gift refers to transfers which are gifts for income tax purposes 
(rather than for gift tax purposes). The commenter noted that many 
common estate planning techniques involve transfers of assets to 
grantor trusts with the transferor as the grantor and the grantor's 
family members as beneficiaries of the trust, and that these types of 
transfers often result in a completed gift for gift tax purposes but do 
not constitute a transfer of ownership for income tax purposes.
    Commenters also recommended that the final regulations exclude 
specific nonrecognition transactions, including (i) transfers resulting 
from the death of an Owner Taxpayer; (ii) gifts to a non-grantor trust 
by an Owner Taxpayer; and (iii) transfers resulting from a change in 
tax status of a grantor trust. One commenter noted that, in light of 
section 1061(d)'s specific reference to section 318(a)(1), and not to 
section 318(a)(2), a gift to a non-grantor trust for the benefit of a 
taxpayer's spouse, children, grandchildren or parents should not be 
considered an ``indirect transfer'' that would trigger the application 
of section 1061(d). The commenter noted that Congress's use of the 
phrase ``directly or indirectly'' does not warrant disturbing the 
conclusion that a transfer to a non-grantor trust does not constitute 
an acceleration event for purposes of section 1061(d). This commenter 
suggested in the alternative that if a transfer to a non-grantor trust 
is an acceleration event for purposes of section 1061(d), only upon a 
subsequent distribution of the API out of the non-grantor trust should 
the acceleration event occur.
    After considering the comments, the Treasury Department and the IRS 
have determined that while section 1061(d) can reasonably be 
interpreted as an acceleration provision, in the absence of clear 
language to the contrary, it is more appropriate to apply section 
1061(d) only to transfers in which long-term capital gain is recognized 
under chapter 1 of the Code. Interpreting section 1061(d) as only a 
recharacterization provision is consistent with the statutory language 
that looks to so much of the taxpayer's long-term capital gain with 
respect to such interest for such taxable year as is attributable to 
the sale or exchange of any asset held. This treatment also prevents 
the acceleration of gain in the many non-abusive nonrecognition 
transactions described by commenters. Furthermore, it is not necessary 
to accelerate gain on the transfers of an API to a Section 1061(d) 
Related Person in a non-taxable transaction because the API will remain 
an API in the hands of the transferee under Sec.  1.1061-2(a). 
Accordingly, the final regulations provide that the Section 1061(d) 
Recharacterization Amount includes only long-term capital gain that the 
Owner Taxpayer recognizes under chapter 1 of the Code upon a transfer 
through a sale or exchange of an API to a Section 1061(d) Related 
Person.
    Proposed Sec.  1.1061-5(c) provides a formula for calculating the 
Owner Taxpayer's short-term capital gain upon a transfer of an API to a 
Section 1061(d) Related Person based upon a hypothetical sale of all of 
the partnership's property in a fully taxable transaction. A commenter 
noted that because the calculation is not based on the 
Recharacterization Amount under a hypothetical liquidation, it includes 
amounts excluded from the Recharacterization Amount, such as

[[Page 5462]]

capital interest gains and losses. The commenter recommended that the 
formula be amended so that it is based upon the Recharacterization 
Amount in a hypothetical partnership liquidation, and that the final 
regulations contain an exception from taxation for transactions in 
which the Owner Taxpayer's deemed distributions with respect to the 
Owner Taxpayer's API on a hypothetical liquidation basis are the same 
immediately before and after the transaction (not including any deemed 
distributions due to changes in debt allocations). Another commenter 
suggested that, in order to avoid double-counting in a tiered 
structure, there should be a cap on the amount that would be taxed 
equal to the gain that would be realized if the directly transferred 
API were sold for its fair market value by the Owner Taxpayer.
    Another commenter noted that the proposed regulations provide that 
section 1061(d) applies to transfers of APIs by Passthrough Entities 
and to transfers of Distributed API Property by Owner Taxpayers, but 
that the rules do not provide guidance on how to calculate the amount 
to be included. The commenter suggested that, in the case of a transfer 
of an API by a Passthrough Entity, the inclusion amount should be the 
amount that would be allocated to each of the Passthrough Entity's 
direct or indirect Owner Taxpayers in a deemed taxable sale of assets 
by the lower-tier entity in which the Passthrough Entity holds its API, 
and that the amounts that such Passthrough Entity includes in the API 
One Year Distributive Share Amount, but not in the API Three Year 
Distributive Share Amount, for each Owner Taxpayer should be subtracted 
from the aforementioned amounts to calculate an Owner Taxpayer's 
recharacterization amount under section 1061(d). In the case of a 
transfer of Distributed API Property by an Owner Taxpayer, the 
commenter suggested that the inclusion amount should be the amount of 
long-term capital gain that the Owner Taxpayer would have recognized on 
a taxable sale for cash at the Distributed API Property's fair market 
value.
    The Treasury Department and the IRS appreciate these thoughtful 
suggestions. The final regulations have revised and simplified the 
computation of the inclusion amount in Sec.  1.1061-5(c) and have added 
the term Section 1061(d) Recharacterization Amount. The final 
regulations provide that, if section 1061(d) applies, an Owner 
Taxpayer's Section 1061(d) Recharacterization Amount is the Owner 
Taxpayer's share of the amount of net long-term capital gain from 
assets held for three years or less that would have been allocated to 
the Owner Taxpayer with respect to the transferred API if the 
partnership had sold all of its property in a fully taxable transaction 
for cash in an amount equal to the fair market value of such property 
immediately prior to the Owner Taxpayer's transfer of the API (or a 
portion of such gain if only a portion of the API is transferred).
    A commenter requested clarification as to whether ``capital gain 
recognized'' on an otherwise taxable transfer in proposed Sec.  1.1061-
5(c)(2) means that the amount recharacterized under section 1061(d) 
includes only gain that would otherwise be treated as long-term gain or 
whether it sets the total amount of short-term gain on the transfer. 
The final regulations provide that the long-term gain that is 
recharacterized to short-term under section 1061(d) is the lesser of 
(i) the amount of net long-term capital gain recognized by the Owner 
Taxpayer upon the transfer of such interest, or (ii) the Section 
1061(d) Recharacterization Amount as computed under Sec.  1.1061-5(c). 
Thus, only gain that would otherwise be treated as long-term gain is 
recharacterized under section 1061(d).
    Proposed Sec.  1.1061-5(d) provides that the basis of a transferred 
API or transferred Passthrough Interest (in the case of a transferred 
Indirect API) is increased by the additional gain recognized. A 
commenter requested that the rule be revised to explicitly coordinate 
with section 743 so that the basis adjustments will be allocated to the 
assets that result in the gain recognition. The concerns raised in this 
comment are resolved because the final regulations limit the 
application of section 1061(d) to transactions in which gain is 
recognized.
    Another commenter recommended that the final regulations explicitly 
exclude amounts that would be subject to the Capital Interest 
Exception. The final regulations do not adopt this comment because the 
Capital Interest Exception is an exception to the definition of an API. 
Therefore, such a rule is not needed. Commenters also recommended that 
the final regulations explicitly exclude amounts specified in proposed 
Sec.  1.1061-4(b)(6) (designated as Sec.  1.1061-4(b)(7) in the final 
regulations) from the calculation of the Section 1061(d) 
Recharacterization Amount. One commenter noted that the scope of 
section 1061(d)(1) is broader than the tax result that would occur if 
the partnership had actually sold all its property, noting that neither 
the statute nor the proposed regulations exclude section 1231 gains 
(and other excluded gains such as those under section 1256) from the 
Section 1061(d) Recharacterization Amount. Another commenter argued 
that section 1061(d) should not recharacterize section 1231 gain, 
stating that while the statutory language in section 1061(d) provides 
arguable authority for including section 1231 gains in the computation 
of the Section 1061(d) Recharacterization Amount, the approach is hard 
to justify from a policy perspective. The commenter argued that because 
section 1061(d) is aimed at preventing an API Holder from circumventing 
section 1061(a), the regulations should not impose on taxpayers a 
result under section 1061(d) that is worse than if section 1061(a) had 
applied to assets sold by the partnership. The commenter recommended 
that ``long-term capital gains'' should be interpreted consistently for 
purposes of section 1061(a) and section 1061(d), and that long-term 
capital gain recognized with respect to section 1231 assets should not 
be recharacterized under either paragraph.
    The final regulations adopt these comments and provide that the 
Section 1061(d) Recharacterization Amount does not include amounts not 
taken into account for purposes of section 1061 under Sec.  1.1061-
4(b)(7).
    Proposed Sec.  1.1061-5(c)(1) provides that if an Owner Taxpayer 
transfers an Indirect API and is subject to section 1061(d), the 
computation of the Section 1061(d) Recharacterization Amount must be 
applied at the level of any lower-tier Passthrough Entities. One 
commenter recommended that this rule be aligned with the rules for 
tiered partnerships elsewhere in the proposed regulations, such as the 
Lookthrough Rule, which explicitly states that it applies only to the 
``assets of the partnership in which the API is held.'' A commenter 
recommended that the final regulations clarify whether the transfer of 
a distributed asset held, or deemed to be held, by the partnership for 
three years or less is subject to section 1061(d). Another commenter 
noted that there is no principled reason for not applying section 
1061(d) in tiered partnerships to transfers of Distributed API Property 
by Passthrough Entities to Section 1061(d) Related Persons of the 
ultimate Owner Taxpayer.
    Under the final regulations, the Section 1061(d) Recharacterization 
Amount is computed by the Owner Taxpayer. The transfer of a distributed 
asset held, or deemed to be held, by a Passthrough Entity for three 
years or less is subject to section 1061(d). The final regulations 
clarify that for

[[Page 5463]]

purposes of section 1061(d), an Owner Taxpayer will be treated as 
transferring the Owner Taxpayer's share of any Indirect API or 
Distributed API Property if the Indirect API or Distributed API 
Property is transferred by the API Holder to a person that is a Section 
1061(d) Related Person with respect to the Owner Taxpayer. The final 
regulations also provide that the rules for determining the Section 
1061(d) Recharacterization Amount also apply to the transfer of a 
Passthrough Interest issued by an S corporation or PFIC to the extent 
the Passthrough Interest is treated as an API.
    Proposed Sec.  1.1061-5(e) defines a Section 1061(d) Related Person 
as: (i) A person that is a member of the taxpayer's family within the 
meaning of section 318(a)(1); (ii) a person that performed a service 
within the current calendar year or the preceding three calendar years 
in a Relevant ATB to the API transferred by taxpayer; or (iii) a 
Passthrough Entity to the extent that a person described in paragraph 
(e)(1)(i) or (ii) owns an interest, directly or indirectly. One 
commenter recommended that the definition of Section 1061(d) Related 
Person be amended to exclude a Passthrough Entity to the extent that a 
member of the taxpayer's family or colleague is an owner, noting that 
language is not in the statute and is not discussed in the legislative 
history. The final regulations do not adopt this comment. Section 
1061(d)(1) provides that the inclusion required by section 1061(d) 
applies if a taxpayer transfers any API, directly or indirectly, to a 
person related to the taxpayer.

III. Additional Comments Received and Revisions Made

A. Sections 1.1061-1 and 1.1061-2: Definitions, Operational Rules, and 
Examples

1. Definitions, In General
    A commenter expressed the view that the interrelated new terms and 
definitions make the proposed regulations difficult to read and 
comprehend in some places. The final regulations largely retain the 
terms and definitions provided in Sec.  1.1061-1(a) but simplify many 
of the computational rules and concepts used to determine the 
Recharacterization Amount and the Section 1061(d) Recharacterization 
Amount. The terms and definitions provide a helpful roadmap to the 
regulations and are also needed to provide Owner Taxpayers, Passthrough 
Entities, and the IRS with a common vocabulary that can be used to 
describe the necessary computations and reporting requirements. The 
final regulations make clarifying changes throughout the definitions, 
including providing that a Passthrough Entity can also be a trust or 
estate. Terms have also been added and removed in accordance with the 
revisions discussed elsewhere in this Summary of Comments and 
Explanation of Revisions.
    A commenter noted that the preamble to the proposed regulations 
provides that ``taxpayer'' means Owner Taxpayer in sections 1061(a) and 
(d), and both Owner Taxpayer and Passthrough Taxpayer in section 
1061(c)(1). The commenter further noted that the proposed regulations 
use the definition of ``person'' as that term is generally used under 
section 7701(a)(1). The commenter requested that the final regulations 
provide explicit definitions of ``taxpayer'' and ``person'' in each 
relevant part because the terms have different meanings in different 
contexts.
    The final regulations do not adopt this comment because defining 
taxpayer and person in different ways in each relevant section would 
introduce unnecessary complexity. However, the use of these terms has 
been modified in certain places in the final regulations to alleviate 
confusion.
2. Operational Rules
a. Definition of API; An API Remains an API
    Proposed Sec.  1.1061-1(a) provides that API means any interest in 
a partnership which, directly or indirectly, is transferred to (or is 
held by) an Owner Taxpayer or Passthrough Taxpayer in connection with 
the performance of substantial services by the Owner Taxpayer or by a 
Passthrough Taxpayer, or by any Related Person, including services 
performed as an employee, in any ATB unless an exception applies, and 
that for purposes of this definition, an interest in a partnership also 
includes any financial instrument or contract, the value of which is 
determined in whole or in part by reference to the partnership 
(including the amount of partnership distributions, the value of 
partnership assets, or the results of partnership operations.)
    A commenter expressed concern that defining an interest in a 
partnership to include a financial instrument or contract, the value of 
which is determined in whole or in part by reference to the 
partnership, could include investment management contracts that provide 
for a fee based on the assets of a fund partnership and not a carried 
interest or other performance allocation, creating a risk that the sale 
of a management company or indirect sale of a management contract could 
be subject to section 1061. This in turn could cause the enterprise 
value of the management company to be taxed at ordinary income rates. 
The commenter recommended that the definition of API be modified to 
exclude financial instruments or contracts that merely reference the 
value of partnership assets or that provide for fee income that is 
subject to ordinary income tax treatment.
    Because financial instruments can replicate the performance of a 
partnership interest, the inclusion of such items in the definition of 
an API is necessary for purposes of implementing section 1061. 
Accordingly, the final regulations do not adopt this comment. As stated 
in Part IV of this Summary of Comments and Explanation of Revisions, 
the Treasury Department and the IRS continue to study the impact of 
section 1061 on the taxation of enterprise value related to the 
transfer or exchange of partnership interests and management contracts.
    Proposed Sec.  1.1061-2(a)(1)(i) provides that once a partnership 
interest qualifies an API, the partnership interest remains an API 
unless and until the requirements of one of the exceptions to 
qualification of a partnership interest as an API are satisfied. A 
commenter questioned whether this provision is valid given that it is 
not explicit in the statute, but reasoned that the rule is implicit in 
the statutory scheme and is necessary to prevent avoidance of the 
statute.
    The Treasury Department and the IRS agree with the commenter that 
this rule is implicit in the statutory scheme. Neither the statute nor 
the legislative history provide a time limit or other means of ending 
API treatment beyond the exceptions to qualification as an API. 
Consequently, no modifications have been made to Sec.  1.1061-
2(a)(1)(i).
b. Presumption That Services are Substantial
    Proposed Sec.  1.1061-2(a)(1)(iv) provides that if a partnership 
interest is transferred to or held by an Owner Taxpayer, Passthrough 
Taxpayer, or any Related Person in connection with the performance of 
services, the Owner Taxpayer, the Passthrough Taxpayer, or the Related 
Person is presumed to have provided substantial services for purposes 
of section 1061. Commenters suggested that presuming all services to be 
substantial is overbroad and recommended that the presumption be 
removed. In addition, one commenter recommended the inclusion of non-
exclusive safe harbors that service partners could rely on to determine 
that

[[Page 5464]]

partnership interests they hold or that have been transferred to them 
are not in connection with the performance of substantial services. 
Another commenter recommended adding a means to rebut the presumption 
that the services are substantial.
    The final regulations retain the proposed rule's presumption that 
all services provided for a partnership interest are substantial 
services for purposes of section 1061. However, the Treasury Department 
and the IRS will continue to study and consider possible circumstances 
under which the presumption might be rebutted as well as the 
possibility of providing safe harbors for circumstances under which the 
presumption will not apply. These considerations may be addressed in 
future guidance.
c. Application of the ATB Activity Test
i. In General, ATB
    Proposed Sec.  1.1061-1(a) provides that applicable trade or 
business (ATB) means any activity for which the ATB Activity Test with 
respect to Specified Actions is met, and includes all Specified Actions 
taken by Related Persons, including combining activities occurring in 
separate partnership tiers or entities as one ATB. Proposed Sec.  
1.1061-1(a) defines an Owner Taxpayer as the person subject to Federal 
income tax on net gain with respect to an API or an Indirect API during 
the taxable year, including an owner of a Passthrough Taxpayer unless 
the owner of the Passthrough Taxpayer is a Passthrough Entity itself or 
is excepted under proposed Sec.  1.1061-3(a), (b), or (d).
ii. ATB Activity Test
    Proposed Sec.  1.1061-2(b)(1) provides that the ATB Activity Test 
is satisfied if Specified Actions are conducted by one or more Related 
Persons and the total level of activity, including the combined 
activities of all Related Persons, satisfies the level of activity that 
would be required to establish a trade or business under section 162. 
Proposed Sec.  1.1061-1(a) provides that Specified Actions means 
Raising or Returning Capital Actions and Investing or Developing 
Actions. Raising or Returning Capital Actions means actions involving 
raising or returning capital but does not include Investing or 
Developing Actions. Investing or Developing Actions means actions 
involving either (i) investing in (or disposing of) Specified Assets 
(or identifying Specified Assets for such investing or disposition), or 
(ii) developing Specified Assets.
    Commenters requested clarification that joint ventures of a real 
estate developer involving a single stand-alone project at a single 
location will not satisfy the ATB Activity Test. One of these 
commenters recommended that the definition of Raising or Returning 
Capital should be refined so that it includes only raising or returning 
capital activities in which the business earns compensation based on 
either capital committed, capital contributed, or capital invested. 
Another commenter noted that additional guidance may be needed to make 
the statute more administrable because real estate held for rental or 
investment is a Specified Asset but holding the property may not 
constitute a trade or business under section 162.
    The final regulations do not adopt these comments. Whether a single 
project or raising of capital involves the level of activity needed to 
constitute a trade or business under section 162 is dependent on the 
facts and circumstances unique to the project or raising of capital. 
Furthermore, guidance under section 162 is beyond the scope of these 
regulations.
    Example 6 of proposed Sec.  1.1061-2(b)(2)(vi) describes a 
situation in which A manages a hardware store that Partnership owns. A 
is issued a profits interest in Partnership in connection with A's 
services. Partnership owns the building in which the hardware store 
operates. The example notes that the building is held by Partnership 
not for rental or investment, but to conduct Partnership's hardware 
business and, thus, the building is not a Specified Asset. The example 
provides that the partnership maintains and manages a certain amount of 
working capital for its business, but notes that working capital is not 
taken into account for the purpose of determining whether the ATB 
Activity Test is met. A commenter suggested that another example should 
be added to analyze how to apply the ATB Activity Test where the facts 
are changed so that the business is held in a C corporation, the 
partnership only holds the C corporation stock, and the holding 
partnership is held by an investment partnership. The commenter stated 
that the ATB Activity Test should not be met by the holding partnership 
and the manager should not be an API Holder.
    The final regulations do not adopt this comment. Depending on the 
specific facts and circumstances of the situation, the Treasury and the 
IRS believe that the ATB Activity Test could be met by such a holding 
partnership and the manager might be an API Holder.
    A commenter requested clarification regarding what activities 
occurring in separate partnership tiers or entities will be considered 
combined and treated as one ATB, and recommended that the regulations 
be amended to include an example illustrating how the ATB and API rules 
work in this situation. The commenter recommended that the application 
of section 1061 be limited to an Owner Taxpayer solely with respect to 
partnership interests that serve as compensation for services relating 
to Specified Assets. Another commenter requested simplifying safe 
harbors for activities conducted in multiple entities either in the 
same chain or in a brother-sister chain.
    The Treasury Department and the IRS continue to study these issues 
and may consider providing future guidance on these matters. However, 
the Treasury Department and the IRS note the definition of ATB includes 
any and all activities, no matter how minimal, conducted by entities 
that are Related Persons to each other, for purposes of determining 
whether the ATB Activity Test is met, and if that test is met, then 
each such participating entity is considered to be engaged in an ATB.
    Another commenter requested clarification that businesses that do 
not both raise or return capital and engage in either investment or 
development activities do not satisfy the ATB Activity Test, and that 
the regular, continuous, and substantial standard applies independently 
to each prong of the ATB Activity Test. The commenter suggested that 
because the proposed regulations aggregate activities of one or more 
entities and related parties, the final regulations should not include 
the statement that the fact that either Raising or Returning Capital 
Actions or Investing or Developing Actions are only infrequently taken 
does not preclude the test from being satisfied if the combined 
Specified Actions meet the test. The commenter expressed concern that 
this language combined with the rule that Raising or Returning Capital 
Actions and Investing or Developing Actions are not required to be 
taken in each taxable year could cause the activities of a fund 
sponsor's affiliates to satisfy the raising or returning capital prong 
with respect to any of the sponsored funds.
    The final regulations do not adopt this comment. It is necessary 
for both the Raising or Returning Capital Actions and Investing or 
Developing Actions to be present for the ATB Activity Test to be 
satisfied. The aggregation rule and the language regarding infrequent 
actions are necessary to prevent abuse of section 1061. Without these 
rules,

[[Page 5465]]

activities could be spread among multiple related entities with the 
intent of not satisfying the ATB Activity Test.
iii. Definition of Specified Assets
    Proposed Sec.  1.1061-1(a) defines Specified Assets as: (i) 
Securities, including interests in partnerships qualifying as 
securities (as defined in section 475(c)(2) without regard to the last 
sentence thereof); (ii) commodities (as defined in section 475(e)(2)); 
(iii) real estate held for rental or investment; (iv) cash or cash 
equivalents; (v) an interest in a partnership to the extent that the 
partnership holds Specified Assets; and, (vi) options or derivative 
contracts with respect to any of the foregoing.
    Commenters requested additional guidance on the treatment of 
partnerships that engage in the production, storage, transportation, 
processing, or marketing of physical commodities in the ordinary course 
of business (including hedges with respect to the commodities). The 
commenters requested that such partnerships not be treated as engaged 
in Investing and Developing Actions as a result of such activities, and 
that Specified Assets only include commodities that are themselves 
actually actively traded on an established financial market, not merely 
commodities of the same type as commodities that are or can be actively 
traded on an established financial market.
    The final regulations do not adopt this comment; however, the 
Treasury Department and the IRS continue to study this issue and may 
address it in future guidance.
    Another commenter noted that it is unclear whether the rule 
treating a derivative contract with respect to a partnership interest 
as a partnership interest for purposes of applying section 1061 is 
needed to appropriately administer section 1061. The commenter noted 
that the proposed regulation's position regarding such a derivative 
injects unnecessary complexity into the tax system, and stated that 
because payments made before termination of a swap are almost always 
ordinary income, it may not make economic or tax sense to use such a 
financial instrument in lieu of a partnership interest in an attempt to 
avoid section 1061.
    The final regulations do not adopt this comment. While the use of a 
derivative contract in this circumstance may be rare, the Treasury and 
the IRS are concerned that the potential for abuse exists. 
Consequently, the treatment of a derivative contract as a partnership 
interest for purposes of applying section 1061 is necessary to prevent 
the circumvention of, and compliance with, section 1061.

B. Section 1.1061-3: Exceptions to the Definition of API

1. Corporate Exception
    Section 1061(c)(4)(A) provides that an API ``shall not include any 
interest in a partnership directly or indirectly held by a 
corporation.'' In implementing this exception, proposed Sec.  1.1061-
3(b)(2) provides that a corporation does not include an entity for 
which an election was made to treat the entity as a Passthrough Entity, 
and that therefore, an S corporation for which an election under 
1362(a) is in effect and a PFIC with respect to which the shareholder 
has a QEF election under section 1295 in effect (such entity is a QEF 
with respect to the shareholder), are not treated as corporations for 
purposes of section 1061. One commenter approved of this decision, 
noting that section 1061(f) provides ample authority for excluding S 
corporations and PFICs from the term corporation. The commenter noted 
that allowing such structures to benefit from the corporate exception 
would allow section 1061 to be entirely circumvented. Another 
commenter, discussing PFICs subject to QEF elections, noted that the 
exclusion of QEFs from the definition of corporation for purposes of 
section 1061 is consistent with section 1(h)(9) and (h)(10).
    One commenter disagreed regarding authority, noting that the 
ability to treat QEFs and S corporations as subject to section 1061 is 
subject to substantial doubt and contrary to the plain text of the 
statute. The commenter also noted that Notice 2018-18, 2018-2 I.R.B. 
443, and the provision's legislative history offer no reason why S 
corporations should, or should not, qualify for the exception. Another 
commenter said that a legislative clarification should be sought prior 
to including a rule in the final regulations providing that S 
corporations are subject to section 1061.
    The Treasury Department and the IRS agree with commenters that the 
exclusion of S corporations and QEFs from the corporate exception is 
necessary to avoid circumvention of section 1061. Accordingly, no 
change has been made to this section of the final regulations. As 
explained in the preamble to the proposed regulations, section 1061(f) 
provides that the Secretary has authority to issue regulations or other 
guidance as is necessary or appropriate to carry out the purposes of 
section 1061. Both the Conference Report and the Blue Book further 
direct the Treasury Department and the IRS to issue regulations to 
address the prevention of abuse of the purposes of the provision. The 
grant of authority in section 1061(f) is sufficient to issue 
regulations providing that the exception in section 1061(c)(4)(A) does 
not include S corporations and PFICs with respect to which shareholders 
have QEF elections in effect. See also section 1(h)(9) and (10).
2. Unrelated Purchaser Exception
    Proposed Sec.  1.1061-3(d) provides that if a taxpayer acquires an 
interest in a partnership (target partnership) by taxable purchase for 
fair market value that, but for the exception in Sec.  1.1061-3(d), 
would be an API, the taxpayer will not be treated as acquiring an API 
if, immediately before the purchase (1) the taxpayer is not related 
within the meaning of section 267(b) or 707(b) to any person who 
provides services in the Relevant ATB, or any service providers who 
provide services to or for the benefit of the target partnership or a 
lower-tier partnership in which the target partnership holds a direct 
or indirect interest; (2) section 1061(d) does not apply to the 
transaction (as provided in Sec.  1.1061-5); and (3) the taxpayer has 
not provided in the past, does not then provide, and does not 
anticipate providing services in the future to, or for the benefit of, 
the target partnership, directly or indirectly, or any lower-tier 
partnership in which the target partnership holds a direct or indirect 
interest.
    A few commenters stated that the proposed regulations are unclear 
as to whether the exception applies only to an API that is directly 
acquired or whether it also applies to an API in which the buyer 
acquired an indirect interest through an upper-tier partnership. One 
commenter recommended that final regulations provide that the exception 
applies to both APIs purchased directly as well as an APIs purchased 
indirectly, noting that the unrelated purchaser might not be able to 
rely on Rev. Rul. 87-115, 1987-2 C.B. 163, to adjust the basis of the 
underlying fund assets to prevent the recognition of built-in gain, as 
fund sponsors generally do not make section 754 elections at the fund 
level. Further, the commenter suggested that the final regulations 
provide that the exception applies regardless of whether the lower-tier 
partnership interest is acquired after the third-party purchases the 
interest in the upper-tier partnership or acquires the upper-tier 
partnership interest by contribution. Another commenter suggested that 
the exception be

[[Page 5466]]

extended to interests in other Passthrough Entities.
    The final regulations do not adopt these comments because of the 
complexity of administering the unrelated purchaser exception through 
tiers of Passthrough Entities. The final regulations make non-
substantive clarifying changes to the rule.
    The preamble to the proposed regulations provides that the 
exception does not apply to an Unrelated Non-Service Partner who 
becomes a partner by making a contribution to a Passthrough Entity that 
holds an API and in exchange receives an interest in the Passthrough 
Entity's API, stating that, in this case, allocations to the Unrelated 
Non-Service Partner with respect to the API are API Gains and Losses 
and retain their character as API Gains and Losses. One commenter noted 
that this exception to the unrelated purchaser exception is not 
explained in the proposed regulations' preamble and suggested that the 
exception to the exception is most likely intended to refer to a 
situation in which an investor makes a contribution in form to an 
upper-tier partnership, which then distributes an API with respect to a 
lower-tier partnership to the contributing upper-tier partner. The 
commenter notes that these transfers might be a purchase of the API by 
the investor from the upper-tier partnership. The Treasury Department 
and the IRS intend that the third-party purchaser exception be limited 
to API purchases and not apply when a third party contributes cash or 
property to a Passthrough Entity holding an API in a transaction 
qualifying for nonrecognition under section 721(a), or any similar 
provision, resulting in the contributor receiving allocations 
attributable to the transferee Passthrough Entity's API.

C. Section 1.1061-4: Computing the Recharacterization Amount

1. Computation of the Recharacterization Amount
    Proposed Sec.  1.1061-4(a)(1) provides that the Recharacterization 
Amount equals the Owner Taxpayer's One Year Gain Amount less the Owner 
Taxpayer's Three Year Gain Amount. The Owner Taxpayer's One Year Gain 
Amount is the sum of the Owner Taxpayer's combined net API One Year 
Distributive Share Amount from all APIs held during the taxable year 
and the Owner Taxpayer's API One Year Disposition Amount. An Owner's 
Taxpayer's Three Year Gain Amount is equal to the Owner Taxpayer's 
combined net API Three Year Distributive Share Amount from all APIs 
held during the taxable year and the Owner Taxpayer's API Three Year 
Disposition Amount. The API One Year and Three Year Distributive Share 
Amounts exclude Capital Interest Gains and Losses. Capital Interest 
Disposition Amounts are not included in the computation of the API One 
Year and Three Year Disposition Amounts because they relate to the 
disposition of a Capital Interest rather than an API.
    Proposed Sec.  1.1061-4(a)(3)(i) provides that the API One Year 
Distributive Share Amount equals the API Holder's distributive share of 
net long-term capital gain from the partnership for the taxable year, 
including capital gain or loss on the disposition of all or a part of 
an API, with respect to the partnership interest held by the API Holder 
calculated without the application of section 1061 less, to the extent 
included in the amount determined under proposed Sec.  1.1061-
4(a)(3)(i)(A), the aggregate of amounts that are excluded from section 
1061 under proposed Sec.  1.1061-4(b)(6), the API Holder's Transition 
Amount for the taxable year; and Capital Interest Gains and Losses as 
determined under proposed Sec.  1.1061-3(c)(2).
    One commenter stated that the definition of API One Year 
Distributive Share Amount does not allow for this amount to be a loss. 
For example, if an Owner Taxpayer holds two APIs and one partnership 
allocates the taxpayer a loss and the other a gain, the loss does not 
offset the gain because the API One Year Distributive Share Amount for 
the partnership that allocated the taxpayer a loss will be zero. The 
commenter recommended allowing the API One Year Distributive Share 
Amount to be less than zero. The final regulations adopt this 
suggestion by revising the computation for the API One Year 
Distributive Share Amount to include both capital gain and loss. In 
addition, the commenter suggested that the final regulations provide 
that if each of the API One Year Distributive Share Amount and the API 
Three Year Distributive Share Amount is greater than zero but the API 
One Year Distributive Share Amount is less than the API Three Year 
Distributive Share Amount, no portion of the API One Year Distributive 
Share Amount is recharacterized as short-term capital gain. The final 
regulations adopt this suggestion by providing that if the One Year 
Gain Amount and the Three Year Gain Amount are both greater than zero 
but the One Year Gain Amount is less than the Three Year Gain Amount, 
none of the One Year Gain Amount is included in the Recharacterization 
Amount for the taxable year. In addition to adopting this comment, the 
final regulations make minor clarifying changes to the computation 
rules.
    Commenters raised several additional concerns related to the 
computation rules. One commenter recommended that regulations provide 
guidance on how losses limited by section 1211 affect the 
Recharacterization Amount. Another commenter noted that the proposed 
regulations do not address how net capital gain is computed or the 
order of steps in doing so under section 1(h)(1). The commenter stated 
that because section 1061(a) recharacterizes what would have been long-
term capital gain as short-term capital gain, it is apparent that 
section 1061(a) must be applied somewhere in the process before the 
application of section 1(h). Further, the proposed regulations do not 
address Sec.  1.1(h)-1, which provides a look-through rule when a 
partnership interest is sold, to determine what portion of the gain on 
sale will be treated as collectibles gain or section 1250 capital gain. 
The commenter also noted that, although section 1231 and section 1256 
gains are excluded from section 1061 by the proposed regulations, a 
sale of a partnership interest holding such assets is not excluded, and 
all the gain is subject to section 1061(a) unless section 751(a) 
applies. Finally, the commenter stated that there is no provision in 
the proposed regulations addressing suspension of the holding period of 
an API when an API owner seeks to obtain a more-than-three-year holding 
period without undertaking additional risk--that is, the hedging of the 
API. The commenter recommended that an express rule be provided, such 
as the rule provided in Sec.  1.1400Z2(a)-1(b) for interests in 
partnerships self-certified as qualified opportunity funds.
    The Treasury Department and the IRS continue to study the issues 
raised by these comments in regard to the computation rules and may 
address them in future guidance.
2. Distributed API Property
    Proposed Sec.  1.1061-1(a) provides that Distributed API Property 
means property distributed by a Passthrough Entity to an API Holder 
with respect to the API if the holding period, as determined under 
sections 735 and 1223, in the API Holder's hands is three years or less 
at the time of disposition of the property by the API Holder.
    A commenter questioned whether the Treasury Department and the IRS 
have the authority to treat Distributed API Property as subject to 
section 1061(a). The commenter further stated that in

[[Page 5467]]

order for the rule to be a valid exercise of regulatory authority, 
distributed property for this purpose should exclude property that, if 
sold by the partnership, would be excluded from section 1061, such as 
property that would generate 1231 and 1256 gains.
    The final regulations continue to treat Distributed API Property as 
subject to section 1061(a) under the authority of section 1061(f). 
However, the Treasury Department and the IRS agree with the commenter 
that long-term capital gain from the disposition of Distributed API 
Property that, if sold by the partnership, would be excluded from 
section 1061, such as 1231 and 1256 gain, qualified dividends described 
in section 1(h)(11)(B), and any other capital gain that is 
characterized as long-term or short-term without regard to the holding 
period rules in section 1222, should not be recharacterized under 
section 1061(a). The final regulations clarify this point by excluding 
these items from the calculation of the API One Year Disposition 
Amount. Additionally, because a Passthrough Entity does not calculate 
an API One Year Disposition Amount, the final regulations clarify that 
for purposes of calculating the API One Year Distributive Share Amount, 
an API Holder's distributive share of net long-term capital gain from 
the partnership includes capital gain or loss on the disposition of 
Distributed API Property or all or part of an API by an API Holder that 
is a Passthrough Entity.
    Another commenter suggested that the final regulations explicitly 
provide rules for the treatment of Distributed API Property when the 
Distributed API Property is distributed from one Passthrough Entity to 
another and the upper-tier entity disposes of the Distributed API 
Property. The commenter also requested confirmation in the final 
regulations that partnerships should subtract capital gain or loss from 
property that had been Distributed API Property but no longer is at the 
time of disposition when calculating the API One Year Distributive 
Share Amount because such gain is excluded from the calculation of the 
Recharacterization Amount.
    The final regulations partially adopt this comment by revising the 
computation of the One Year Distributive Share Amount to explicitly 
include dispositions of API Distributed Property by a partnership or 
other Passthrough Entity. The final regulations do not adopt the 
suggestion to explicitly provide that partnerships should subtract 
capital gain or loss from property that had been Distributed API 
Property but no longer is at the time of disposition when calculating 
the API One Year Distributive Share Amount. The definition of 
Distributed API Property provides that it only applies to property with 
a holding period of three years or less on the date of disposition by 
an API Holder. Any property with a greater than three-year holding 
period is therefore not Distributed API Property. A special rule for 
Distributed API Property distributed to an upper-tier entity by a 
lower-tier entity is unnecessary because the definition of API Holder 
includes a Passthrough Entity.
    Commenters noted that the proposed regulations are unclear as to 
how the Distributed API Property rules apply where an API Holder owns 
both a profits interest and a capital interest in a partnership, and 
recommended that the final regulations clarify that a distribution to a 
partner is not Distributed API Property to the extent that it is 
distributed with respect to the portion of the partner's interest 
qualifying for the Capital Interest Exception. One commenter suggested 
that such guidance should also address how to apply the recommended 
rule in the context of tiered structures.
    The Treasury Department and the IRS continue to study this issue 
and may address it in future guidance.
3. Special Rules for Capital Gain Dividends From Regulated Investment 
Companies (RICs) and Real Estate Investment Trusts (REITs)
    The preamble to the proposed regulations recognizes that long-term 
capital gain treatment should be available for a capital gain dividend 
paid by a RIC or REIT to the extent that the capital gain dividend is 
attributable to assets held for more than three years or is 
attributable to assets that are not subject to section 1061. Proposed 
Sec.  1.1061-4(b)(4) facilitates this treatment by allowing a RIC or 
REIT to disclose two additional amounts based on modified computations 
of the RIC's or REIT's net capital gain. First, the RIC or REIT may 
disclose the amount of the capital gain dividend that is attributable 
to the RIC's or REIT's net capital gain excluding any amounts not taken 
into account for purposes of section 1061 under proposed Sec.  1.1061-
4(b)(6) from the computation. Second, the RIC or REIT may disclose the 
amount of the capital gain dividend that is attributable to the RIC's 
or REIT's net capital gain both (1) excluding any amounts not taken 
into account for purposes of section 1061 under proposed Sec.  1.1061-
4(b)(6) from the computation, and (2) substituting three years for one 
year in applying section 1222. The proposed regulations allow a RIC or 
REIT to disclose these two additional amounts in writing to its 
shareholders with its section 852(b)(3)(C)(i) capital gain dividend 
statement or section 857(b)(3)(B) capital gain dividend notice.
    One commenter suggested that it would be extremely rare for a RIC 
to have shareholders for whom this provision is relevant and stated 
that requiring this additional reporting would be unnecessarily 
burdensome as it creates a third type of capital gain that RICs would 
need to track and report. Consequently, the commenter requested that 
final regulations continue to permit, but not require, RICs to report 
this information if they have a shareholder for whom such amounts are 
relevant. In addition, the commenter noted that most funds will not 
calculate this information at the time capital gain dividends are 
reported on Forms 1099-DIV. The commenter requested that final 
regulations allow reporting on a written statement furnished to the 
applicable shareholder on request, without tying the reporting of such 
amounts to the reporting of capital gain dividends.
    Another commenter suggested that RICs and REITs should be permitted 
to disclose these additional amounts, upon request by a shareholder, 
and report the One Year Amounts Disclosure and Three Year Amounts 
Disclosure (as those terms are defined in proposed Sec.  1.1061-6(c)) 
until the extended due date of their returns.
    The final regulations retain the rules as proposed but designate 
them as Sec.  1.1061-4(b)(5). As suggested by these commenters, the 
final regulations retain the option to disclose to shareholders the two 
additional amounts (that is the final regulations do not make 
disclosure mandatory). The final regulations do not adopt the 
suggestion to allow RICs and REITs to disclose these additional amounts 
only upon the request of a shareholder because such treatment may allow 
a RIC or REIT to choose to provide information only to certain 
shareholders but not to other shareholders. The Treasury Department and 
the IRS continue to study comments suggesting that the disclosure of 
this information be separated from the reporting of capital gain 
dividends and may issue guidance in the future. In the interim, the 
final regulations retain the rule that the disclosures are to be 
provided with the section 852(b)(3)(C)(i) capital gain dividend 
statement or section 857(b)(3)(B) capital gain dividend notice.

[[Page 5468]]

4. Computation of the Recharacterization Amount for Owner Taxpayers 
With Interests in QEFs
    The proposed regulations provide special rules for Owner Taxpayers 
that hold their APIs indirectly through PFICs for which they have made 
a QEF election. Specifically, under proposed Sec.  1.1061-4(b)(5), the 
API One and Three Year Distributive Share Amounts include an Owner 
Taxpayer's section 1293(a)(1) inclusions from QEFs, reduced by amounts 
that are excluded from section 1061(a) if the QEF complies with the 
reporting rules under Sec.  1.1061-6(d). These reporting rules provide 
that QEFs may provide information to allow Owner Taxpayers to compute 
their Recharacterization Amount. If a QEF fails to provide such 
information, an Owner Taxpayer includes its entire pro rata share of 
the QEF's net capital gain in its API One Year Distributive Share 
Amount and no portion of its pro rata share of the QEF's net capital 
gain is ultimately included in its API Three Year Distributive Share 
Amount. One commenter made several suggestions regarding the 
computation of an Owner Taxpayer's API One Year Distributive Share 
Amount and API Three Year Distributive Share Amount with respect to a 
QEF's net capital gain. Broadly, the commenter expressed a concern that 
the corporate-level capital gain netting rules applicable to QEFs are 
not consonant with the requirement that the Recharacterization Amount 
be computed at the Owner Taxpayer level. A QEF determines its net 
capital gain at the corporate level, and may do so in one of three 
ways: First, the QEF may calculate and report the amount of each 
category of long-term capital gain described in section 1(h) of the 
Code; second, the QEF may report its net capital gain for the year and 
state that it is subject it to the highest capital gain rate of tax 
applicable to the shareholder; or third, the QEF may determine its 
current earnings and profits (E&P) and report the entire amount as 
ordinary earnings. Section 1.1293-1(a)(2). A QEF's net capital gain is 
limited to its current E&P, regardless of how it computes such amount 
under Sec.  1.1293-1(a)(2) (QEF E&P limitation). Section 1293(e)(2). 
The commenter had several suggestions on how to clarify or improve the 
rules under section 1061 applicable to QEFs.
    First, the commenter suggested that the three year QEF net capital 
gain provision was not entirely clear, particularly in regard to the 
API Three Year Distributive Share Amount. The commenter recommended 
that the final regulations clarify that an Owner Taxpayer includes in 
its API Three Year Distributive Share Amount the same base amount as 
determined for the API One Year Distributive Share Amount (as adjusted 
to reflect only net long-term capital gains and losses calculated by 
substituting a greater-than-three-year holding period for a greater-
than-one-year holding period).
    The Treasury Department and the IRS confirm that an Owner 
Taxpayer's API Three Year Distributive Share Amount is based on the 
amount computed for its API One Year Distributive Share Amount and 
adjusted to include only items that would be treated as a long-term 
gain or loss if three years were substituted for one year in paragraphs 
(3) and (4) of section 1222 if the QEF satisfies certain reporting 
obligations. See Sec.  1.1061-6(d). However, the final regulations 
revise proposed Sec.  1.1061-4(b)(5) (designated as Sec.  1.1061-
4(b)(6) in the final regulations) to more precisely identify the inputs 
for computing an Owner Taxpayer's API One and Three Year Distributive 
Share Amounts and illustrate an Owner Taxpayer's API Three Year 
Distributive Share Amount computation with respect to a QEF. 
Specifically, Sec.  1.1061-4(b)(6)(i) provides that an Owner Taxpayer's 
inclusion under section 1293(a)(1)(B) that is taken into account in 
determining the API One Year Distributive Share Amount with respect to 
a QEF is limited to the QEF's E&P by section 1293(e)(2) and that the 
section 1293(a)(1)(B) inclusion may be reduced by the Owner Taxpayer's 
share of the excess (if any) of the Capital Interest Gain over Capital 
Interest Loss with respect to the QEF as well as amounts not taken into 
account for purposes of section 1061 pursuant to Sec.  1.1061-4(b)(7). 
In either case, however, Sec.  1.1061-4(b)(6)(i) permits such 
reductions only if a QEF has provided an Owner Taxpayer with the 
relevant information necessary for the Owner Taxpayer to determine 
those amounts.
    Additionally, Sec.  1.1061-4(b)(6)(ii) of the final regulations 
provides that the minuend of an Owner Taxpayer's API Three Year 
Distributive Share Amount computation (under Sec.  1.1061-4(a)(3)(ii)) 
includes its entire amount determined under Sec.  1.1061-4(b)(6)(i) 
(one year QEF net capital gain). The final regulations further provide 
that if the QEF does not provide the Owner Taxpayer with information 
necessary under Sec.  1.1061-6(d) to determine the amount of its 
section 1293(a)(1)(B) inclusion (less any allowed reductions) with 
respect to the QEF that would be included in its API One and Three Year 
Distributive Share Amounts, then the entire amount of the Owner 
Taxpayer's one year QEF net capital gain (less any allowed reductions) 
is also included in the subtrahend of its API Three Year Distributive 
Share Amount formula (under Sec.  1.1061-4(a)(3)(ii)(A)). This results 
in an Owner Taxpayer's entire section 1293(a)(1)(B) inclusion (less any 
allowed reductions) being treated as short-term capital gain. However, 
if the QEF provides the Owner Taxpayer with the additional necessary 
information, then the Owner Taxpayer includes only the amount of its 
one year QEF net capital gain amount that would not be treated as long-
term capital gain substituting a greater-than-three-year holding period 
in applying paragraphs (3) and (4) of section 1222 in the subtrahend of 
this formula (under Sec.  1.1061-4(a)(3)(ii)(A)). This can result in a 
portion of an Owner Taxpayer's section 1293(a)(1)(B) inclusion being 
characterized as long-term capital gain with the balance being treated 
as short-term capital gain.
    To illustrate, assume an Owner Taxpayer owns an interest in a QEF 
that holds an API; the Owner Taxpayer owns no other API directly or 
indirectly. The QEF generates both long- and short-term capital gain in 
its taxable year, none of which are amounts described in Sec.  1.1061-
4(b)(7) or Capital Interest Gains; the Owner Taxpayer's pro rata share 
of the QEF's long-term capital gain is $100, $70 of which would not be 
long-term capital gain if a greater-than-three-year holding period were 
used in applying paragraphs (3) and (4) of section 1222, and its share 
of the QEF's short-term capital gain (determined without regard to 
section 1061) is $15. Before applying section 1061, under Sec.  1.1293-
1(a)(2), the Owner Taxpayer's pro rata share of the QEF's net capital 
gain is $100. Under Sec.  1.1061-4(b)(6)(i), with respect to the QEF, 
the Owner Taxpayer's one year QEF net capital gain amount, and thus its 
API One Year Distributive Share Amount, is $100. In its API Three Year 
Distributive Share Amount computation with respect to the QEF, this 
$100 is the minuend (under Sec.  1.1061-4(a)(3)(ii)). If the QEF does 
not provide the Owner Taxpayer with information to determine how much 
of its pro rata share of the QEF's net capital gain would constitute 
long-term capital gain if a greater-than-three-year holding period were 
used in applying paragraphs (3) and (4) of section 1222, the Owner 
Taxpayer would include all $100 under Sec.  1.1061-4(a)(3)(ii)(A) in 
the subtrahend of its computation. This results in an API Three Year 
Distributive Share Amount of $0 with respect to the QEF (that is: $100 
under Sec.  1.1061-4(a)(3)(ii)

[[Page 5469]]

introductory text, minus $100 under Sec.  1.1061-4(a)(3)(ii)(A)) and a 
Recharacterization Amount of $100 (that is, $100 API One Year 
Distributive Share Amount minus $0 API Three Year Distributive Share 
Amount). However, if the QEF does provide the Owner Taxpayer with this 
information, the Owner Taxpayer includes $70 in the subtrahend of its 
API Three Year Distributive Share Amount computation with respect to 
the QEF under Sec.  1.1061-4(a)(3)(ii)(A). This results in an API Three 
Year Distributive Share Amount of $30 (that is: $100 under Sec.  
1.1061-4(a)(3)(ii) introductory text, minus $70 under Sec.  1.1061-
4(a)(3)(ii)(A)) and a $70 Recharacterization Amount (that is: $100 API 
One Year Distributive Share Amount minus $30 API Three Year 
Distributive Share Amount).
    Additionally, the commenter asked that the final regulations 
harmonize the QEF reporting rules with the reporting rules applicable 
to other Passthrough Entities. Specifically, the commenter requested 
that if a QEF does not report relevant information, then QEF 
shareholders that are Owner Taxpayers should be able to substantiate 
amounts included in the API One Year Distributive Share Amount and 
Three Year Distributive Share Amount, as well as items excluded from 
section 1061(a), through alternative means.
    The Treasury Department and the IRS have concluded that, when 
coupled with Sec.  1.1061-6(d), the QEF reporting rules in Sec.  
1.1295-1(g) provide a sufficiently comprehensive framework for 
information reporting and no additional rule for section 1061 is 
necessary. Under Sec.  1.1295-1(g)(1), for a PFIC to be treated as a 
QEF by its shareholders it must provide either an annual statement 
including the shareholder's pro rata share of the QEF's net capital 
gain for the year or a statement that it has granted its shareholders 
access to its books and records (or other documents) for the purpose of 
determining those amounts; under Sec.  1.1295-1(g)(3), the same 
information must be reported to indirect PFIC shareholders on an 
intermediary statement. Under Sec.  1.1295-1(g)(2), in ``rare and 
unusual circumstances,'' a PFIC can provide alternative documentation 
if it obtains a private letter ruling from, and enters into a closing 
agreement with, the IRS. In addition to these reporting requirements, 
Sec.  1.1061-6(d) permits (but does not require) a QEF to provide its 
shareholders that are Owner Taxpayers with additional information for 
the purpose of determining the Owner Taxpayer's API One Year 
Distributive Share Amount and Three Year Distributive Share Amount.
    The Treasury Department and the IRS have determined that the 
reporting mechanisms under Sec. Sec.  1.1295-1(g) and 1.1061-6(d) 
provide sufficient avenues for an Owner Taxpayer to obtain information 
from a QEF to determine its API One Year Distributive Share Amount and 
Three Year Distributive Share Amount. A special rule allowing Owner 
Taxpayers to substantiate QEF information through alternative means for 
purposes of section 1061 would also run counter to Sec.  1.1295-1(g), 
which generally requires a QEF, and not its shareholders, to report 
information for purposes of section 1293. As a result, to reconcile the 
optional nature of QEF reporting as compared with reporting 
requirements of other Passthrough Entities, the final regulations 
revise Sec.  1.1061-6(b)(2)(ii) to provide that a Passthrough Entity 
from which information is requested must provide such information, but 
only to the extent the information is necessary for the requesting 
Passthrough Entity to meet its reporting and filing requirements under 
Sec.  1.1061-6. The final regulations also revise Sec.  1.1061-6(d) to 
provide that Owner Taxpayers are not permitted to separately 
substantiate amounts with respect to a QEF under Sec.  1.1061-6(a)(2). 
Accordingly, the comments suggesting changes to the QEF reporting rules 
under section 1061 are not adopted.
    The commenter also suggested that the final regulations should 
provide guidance on how to apportion the QEF E&P limitation for 
purposes of section 1061. Specifically, the commenter suggested that 
the QEF E&P limitation should be apportioned according to the 
shareholder's relative share of the API One Year Distributive Share 
Amount and the API Three Year Distributive Share Amount with respect to 
the QEF. The commenter also suggested that consideration be given to 
bypassing netting at the PFIC level, with guidance to be provided on 
how to allocate the QEF E&P limitation at the Owner Taxpayer level.
    The QEF E&P limitation is imposed by section 1293(e)(2) and is 
taken into account in determining a shareholder's pro rata share of the 
net capital gains of a QEF that is required to be included in a 
shareholder's income pursuant to section 1293(a)(1). Netting of losses 
must therefore be carried out before determining the net capital gain 
of a QEF that is required to be included by a shareholder. The Treasury 
Department and the IRS recognize the complexity regarding apportioning 
the QEF E&P limitation for purposes of section 1061. This issue is 
particularly acute in light of the different types of capital gain and 
loss relevant for purposes of section 1061 that may be included in a 
QEF's net capital gain, including one- and three-year capital gains and 
losses, and amounts excluded from section 1061 under Sec.  1.1061-
4(b)(7) or under the capital interest exception. Further complication 
arises from the fact that a loss may arise either from a QEF's ordinary 
business operations, or from one or more of the four categories listed 
in the prior sentence.
    In this regard, the Treasury Department and the IRS considered 
several possible ways of apportioning the QEF E&P limitation. One 
possibility would be to adopt an approach that apportions the QEF E&P 
limitation between the relevant types of capital gains for purposes of 
section 1061 on a pro rata basis, which the Treasury Department and the 
IRS determined would be appropriate in many circumstances, though not 
all. For example, if a loss arises from a QEF's ordinary business 
operations while its capital gain income is derived from an API, there 
may be no direct link between the ordinary loss and the API-derived 
capital gain. In such a case a pro rata approach may be appropriate. 
Alternatively, for other circumstances, the Treasury Department and the 
IRS considered apportioning a QEF's E&P limitation based on more 
specific ordering rules. For example, if a loss were related to one or 
more categories of capital gain, allocation first to those categories 
might be appropriate. Another possible approach would be to allocate 
the loss giving rise to the E&P limitation in the manner that most 
closely approximates how an Owner Taxpayer would be permitted to 
allocate the loss if the QEF's gains and losses were derived directly 
by the Owner Taxpayer and the Owner Taxpayer's income was limited to 
otherwise-long-term capital gain income. In light of the complexity 
regarding the different scenarios under which a pro rata approach or an 
alternative approach would be more appropriate, the Treasury Department 
and the IRS have determined that this issue warrants further study and 
welcome comments in this regard. Until the Treasury Department and the 
IRS issue further guidance on this issue, taxpayers may adopt any 
reasonable method for apportioning the QEF E&P limitation for purposes 
of section 1061 taking into account these considerations.
    Finally, the commenter requested that the Treasury Department and 
the IRS provide a rule that would identify an Owner Taxpayer's 
distributive share of a QEF's net capital gain from a

[[Page 5470]]

Passthrough Entity attributable to the Owner Taxpayer's qualifying 
capital interest and API. The Treasury Department and the IRS continue 
to study this issue and may address it in future guidance.
5. Items Not Taken Into Account for Purposes of Section 1061
    Proposed Sec.  1.1061-4(b)(6) provides that certain items of long-
term capital gain and loss are excluded from the calculation of the API 
One Year Distributive Share Amount and the API Three Year Distributive 
Share Amount. Specifically, long-term capital gain and long-term 
capital loss determined under section 1231 or 1256, qualified dividends 
included in net capital gain for purposes of section 1(h)(11)(B), and 
capital gains or losses that are characterized as long-term or short-
term without regard to the holding period rules in section 1222 are 
excluded from these calculations.
    Two commenters questioned the exclusion of long-term capital gain 
determined under section 1231 from recharacterization under section 
1061. Those commenters discussed the discrepancies in language between 
section 1061(a)(1) and 1061(a)(2), noting that only section 1061(a)(2) 
refers to section 1222. Both commenters suggested that the treatment of 
section 1231 gains in the proposed regulations is contrary to the 
statutory text of section 1061. The first commenter stated that section 
1061(a)(1) applies to net long-term capital gain and noted that other 
portions of section 1061 indicate that it is supposed to apply to gains 
that are taxed at favorable rates for disposition of investment assets. 
This commenter argued that the reference to section 1222 in section 
1061(a)(2) can be read as excluding certain section 1222 gains from the 
reach of section 1061(a), rather than limiting section 1061(a) to such 
gains by implication. The commenter noted that if a determination is 
made that section 1061(a) does apply to section 1231, then regulations 
need to address the holding periods of section 1231 and how the netting 
rules of section 1231 interact with section 1061.
    The second commenter suggested that, under the proposed 
regulations, the portion of any net section 1231 gains attributable to 
APIs could arguably be included in the amount described in section 
1061(a)(1). The commenter stated that this would lead to nonsensical 
results if net section 1231 gains are included in the amount described 
in section 1061(a)(1) but excluded from the amount described in section 
1061(a)(2). Because of the conflicting statutory language in sections 
1061(a)(1) and 1061(a)(2), the commenter recommended that the treatment 
of section 1231 gains be reconsidered, suggesting that one approach 
would be to include the net 1231 gain attributable to APIs in the 
section 1061(a) computation after recomputing this amount by 
substituting 3 years for 1 year.
    In contrast, several commenters supported the proposed regulation's 
treatment of qualified dividends and long-term capital gains determined 
under section 1231 and 1256 as not subject to recharacterization under 
section 1061 and recommended these provisions be finalized as proposed. 
Commenters noted that this treatment aligns with the clear language of 
the statute and is consistent with Congressional intent. One commenter 
stated that section 1256 amounts should not be subject to section 
1061(a) because they are not gains that are taxed at favorable rates 
that arise from the disposition of assets. Another commenter noted that 
the statutory references to section 1223(3) and (4) raise the question 
of section 1061's potential effect on other Code provisions without 
regard to section 1222. The commenter indicated that some provisions 
have their own holding period, such as section 1231, while others, such 
as section 1256, just mandate tax treatment. The commenter stated that 
this results in a haphazard inclusion or exclusion of items from 
section 1061 and noted that because the section 1061 legislative 
history is devoid of guidance on this issue, the approach taken in the 
proposed regulations is reasonable but a technical correction from 
Congress would be welcome.
    The final regulations do not adopt suggestions that section 1231 
gain should be subject to recharacterization under section 1061(a) and 
maintain the rules in proposed Sec.  1.1061-4(b)(6), which is 
designated as 1.1061-4(b)(7) in the final regulations. As stated in the 
preamble to the proposed regulations, section 1231 gains and losses are 
treated as long-term based on the operation of section 1231, and not by 
reference to paragraphs (3) and (4) of section 1222. Similarly, section 
1256 provides for specific character treatment and does not calculate 
gain by reference to section 1222. Accordingly, the Treasury Department 
and the IRS have determined that it is appropriate to exclude these 
amounts from both the One Year and Three Year Gain Amounts. In 
contrast, because section 1061(d)(1) looks to the excess of long-term 
capital gains with respect to the transferred interest to the sale or 
exchange of any asset held for not more than three years as is 
allocable to such interest over what is otherwise short-term capital 
gain under section 1061(a), and does not reference section 1222, these 
amounts are captured in transactions to which section 1061(d) applies. 
The final regulations do not adopt the suggestion to provide guidance 
on section 1231 holding periods or netting rules because such guidance 
would be beyond the scope of these final regulations.
    One commenter suggested that proposed Sec.  1.1061-4(b), which 
excludes certain items from the calculation of the API One Year and 
Three Year Distributive Share Amounts, should be modified to explicitly 
reference both One Year Disposition Gains and One Year Distributive 
Share Amounts in providing for an exclusion of section 1231 property 
from the scope of section 1061. The commenter suggested that the 
Treasury Department and the IRS should also determine whether a similar 
modification is appropriate for the exclusion for section 1256 
property.
    The final regulations do not adopt this comment. The API One Year 
Disposition Amount includes long-term capital gains and losses 
recognized by an Owner Taxpayer on the disposition of all or a portion 
of an API. Pursuant to section 741, the sale or exchange of a 
partnership interest, including an API, is the sale or exchange of a 
capital asset. Accordingly, the character of the gain is determined 
with reference to section 1222. The items listed in Sec.  1.1061-
4(b)(7), including section 1231 gain, are excluded from the calculation 
of the API One Year and Three Year Distributive Share Amounts because 
they are not determined without regard to section 1222. Furthermore, 
asymmetrical tax treatment occasionally is a result of the difference 
between the sale of a partnership interest and the sale of assets by a 
partnership.
    One commenter noted that under section 197(f), acquired goodwill is 
treated as depreciable property, thereby causing gain recognized on the 
sale of acquired goodwill to be treated as section 1231 gain. By 
contrast, self-created goodwill does not qualify as an amortizable 
intangible under section 197; therefore, any gain recognized on the 
sale of the self-created goodwill is not section 1231 gain. Instead, it 
is treated as a capital asset giving rise to capital gain upon a sale 
or exchange. Consequently, under the proposed regulations, gain on the 
sale of acquired goodwill is excluded from the Recharacterization 
Amount while gain on the sale of self-created goodwill is not excluded. 
The commenter

[[Page 5471]]

recommended that in addition to the exclusion for section 1231 gain, 
the regulations should provide that any gain recognized on the sale of 
goodwill held in connection with the conduct of a trade or business 
(whether or not determined under section 1231) is also excluded from 
the Recharacterization Amount because there is no evidence Congress 
intended to subject self-created goodwill held in connection with a 
trade or business to section 1061.
    The final regulations do not adopt this comment. The disparate 
treatment of purchased and self-created goodwill is prescribed by 
section 197 and nothing in section 1061 changes this treatment.
6. Holding Periods
    Proposed Sec.  1.1061-4(b)(8) clarifies that the relevant holding 
period of either an asset or an API is determined under all provisions 
of the Code or regulations that are relevant to determining whether the 
asset or the API has been held for the long-term capital gain holding 
period by applying those provisions as if the holding period were three 
years instead of one year. For this purpose, the relevant holding 
period is the direct owner's holding period in the asset sold.
    The final regulations maintain this rule as proposed. One commenter 
requested clarification that the modification of a partnership 
agreement does not itself create a new holding period for the API. The 
final regulations do not adopt this comment as section 1061 does not 
generally change the holding period of an asset.
7. API Holder Transition Amounts and Partnership Transition Amounts
    The proposed regulations provide that a partnership that was in 
existence as of January 1, 2018, could irrevocably elect to treat all 
long-term capital gains and losses recognized from the disposition of 
all assets held by the partnership for more than three years as of 
January 1, 2018, as Partnership Transition Amounts. An amount of long-
term gain or loss treated as a Partnership Transition Amount and 
included in the allocation of long-term capital gains and losses under 
sections 702 and 704 to an API Holder with respect to its interest in a 
Passthrough Entity was treated as an API Holder Transition Amount. API 
Holder Transition Amounts were not taken into account for purposes of 
determining the Recharacterization Amount. The preamble to the proposed 
regulations also requests comments on whether a transition rule is 
needed and whether the Partnership Transition Amount rules are useful 
or whether another approach would be more helpful in easing transition 
difficulties.
    Several commenters questioned the need for an elective transition 
rule. One commenter noted that while they appreciated the Treasury 
Department and the IRS seeking to minimize the burdens associated with 
the change in law, they did not believe the transition rules would 
measurably lessen the recordkeeping burden on funds. The commenter also 
noted that whether and for whom the transition rules would be 
beneficial is unpredictable. Another commenter recommended that final 
regulations include an example illustrating, or otherwise better 
explaining, the importance of the API Holder Transition Amount rules, 
that is, what benefits the API Holder Transition Amount rules are 
intended to confer on taxpayers. No commenter provided an example of 
the potential applicability of the API Holder Transition Amount rules. 
After considering the comments, the Treasury Department and the IRS 
have determined that the Partnership Transition Amount rules are 
unnecessary. Accordingly, the final regulations do not include these 
rules.

D. Section 1.1061-6: Reporting Requirements

    Proposed Sec.  1.1061-6(a) provides filing and reporting 
requirements for Owner Taxpayers and Passthrough Entities. Proposed 
Sec.  1.1061-6(a)(1) provides that an Owner Taxpayer must file such 
information with the IRS as the Commissioner may require in forms, 
instructions, or other guidance as is necessary for the Commissioner to 
determine that the Owner Taxpayer is in compliance with section 1061 
and the regulations. Proposed Sec.  1.1061-6(b)(1) provides that a 
Passthrough Entity must file such information with the IRS as the 
Commissioner may require in forms, instructions, or other guidance as 
is necessary for the Commissioner to determine that the Passthrough 
Entity and its partners have complied with section 1061 and the 
regulations and that a Passthrough Entity that has issued an API must 
furnish to the API Holder, including an Owner Taxpayer, such 
information at such time and in such manner as is necessary to 
determine the One Year Gain Amount and the Three Year Gain Amount with 
respect to the Owner Taxpayer that directly or indirectly holds the 
API.
    Proposed Sec.  1.1061-6(a)(2) provides that if a Passthrough Entity 
does not furnish the information that an Owner Taxpayer needs to 
determine its Recharacterization Amount and meet its reporting 
requirements, and the Owner Taxpayer is not able to otherwise 
substantiate all or a part of those amounts to the satisfaction of the 
Secretary, then (i) the negative adjustments under proposed Sec.  
1.1061-4(a)(3)(i)(B) necessary to calculate the API One Year 
Distributive Share Amount will be deemed to equal zero, and (ii) the 
negative adjustment to the API One Year Distributive Share Amount for 
purposes of determining the API Three Year Distribution Amount under 
proposed Sec.  1.1061-4(a)(3)(ii)(B) will be deemed to equal zero.
    Proposed Sec.  1.1061-6(b)(2) provides that a Passthrough Entity 
that holds an interest in a lower-tier entity and needs information 
from the lower-tier entity to meet its reporting obligations under the 
proposed regulations must request such information from that entity by 
the later of the 30th day after the close of the taxable year to which 
the information request relates or within 14 days after the date of a 
request for information from an upper-tier Passthrough Entity and the 
lower-tier entity must respond by the due date (including extensions) 
of the Schedule K-1 for the taxable year. Proposed Sec.  1.1061-
6(b)(2)(vii) provides that a Passthrough Entity that fails to comply 
with the reporting rules in the proposed regulations or as further 
required in forms, instructions, or other guidance will be subject to 
penalties.
    One commenter stated that the reporting rules are based on the 
assumption that there will be a limited number of individuals who are 
in control and who have access to all relevant factual information. 
Consequently, the rules are extensive and smaller partnerships and non-
controlled partnerships may have difficulty complying without 
significant cost and expense. The commenter suggested this argued in 
favor of exempting small partnerships from these rules.
    A few commenters stated that lower-tier passthrough entities are 
not required to furnish information until the due date of their returns 
and that this deadline does not permit upper-tier entities sufficient 
time to incorporate lower-tier passthrough entity information into 
their reporting. Further, the commenter noted that the regulations 
appear to prevent Owner Taxpayers from excluding anything from the API 
One Year Distributive Share Amount even if only part of the information 
cannot be substantiated. The commenter recommended that for groups of 
non-controlled entities, the requestor should be allowed any reasonable 
approach to substantiate the information and suggested that issues from 
non-compliant tiers should be resolved by having the IRS impose

[[Page 5472]]

failure to furnish penalties on those tiers. Finally, the commenter 
recommended guidance on how to substantiate unreported amounts.
    Several commenters suggested that the information reporting 
requirements are onerous and that denying exclusions from 
recharacterization for non-compliance is too harsh a penalty for Owner 
Taxpayers and upper-tier partnerships who are unable to secure the 
necessary information from lower-tier partnerships, particularly where 
an Owner Taxpayer or upper-tier partnership has no control over whether 
the reporting requirements are met by the lower-tier partnership. One 
commenter argued that there is no indication in the statute or 
legislative history that this is what Congress intended. The commenter 
noted that the TCJA conference report indicates that Congress intended 
section 6031(b) penalties to apply to a failure to report to partners 
and those penalties are sufficient to deter non-compliance while not 
acting to change the character of distributive share items.
    A few commenters noted that the reporting requirements will require 
significant amendments to partnership agreements and reporting systems. 
These commenters requested that the effective date for the reporting 
requirements and associated penalties be delayed until at least 12 
months after the year end in which the regulations are finalized to 
give funds and API Holders time to amend their operations and establish 
proper information reporting systems, particularly in light of the 
increased reporting requirements resulting from partner tax capital 
account reporting, Forms K-2 and K-3, the section 163(j) limitation, 
and other recent guidance.
    One commenter suggested that the regulations should provide a de 
minimis exception to the reporting requirements, especially in tiered 
partnership arrangements. The commenter suggested that if a limited 
partner owns less than five percent of a fund, there should be 
limitations on reporting requirements to those partners, arguing that 
information reporting is costly in a tiered fund context and the lower-
tiered funds may not want to dedicate the resources to provide the 
proper reporting for such small fund interests.
    The final regulations do not adopt these comments. The reporting 
rules, including the zero presumptions, are necessary to effectively 
administer section 1061 and the regulations. The Treasury Department 
and the IRS note that the amounts required to be reported under the 
reporting rules may be substantiated by any reasonable means if a 
Passthrough Entity fails to report the necessary information to the 
Owner Taxpayer. Similarly, a de minimis rule or an exception for small 
partnerships would frustrate Owner Taxpayers' ability to correctly 
determine the Recharacterization Amount and the IRS's ability to 
administer the statute. For these reasons, the Treasury Department and 
the IRS also decline to provide a delay in the applicability date for 
the reporting rules.
    The final regulations retain the reporting rules as proposed with 
minor clarifying changes, including the changes discussed in paragraph 
III.C.4 of this preamble with respect to QEF reporting. In addition, 
the final regulations provide that if an Owner Taxpayer requires 
information from a Passthrough Entity to determine the Section 1061(d) 
Recharacterization Amount, the Owner Taxpayer should request such 
information from that entity. The Passthrough Entity is required to 
provide the information to the extent requested by an API Holder and 
necessary to determine the Owner Taxpayer's Section 1061(d) 
Recharacterization Amount. Finally, the final regulations substitute 
``Commissioner'' for ``Secretary of the Treasury'' in Sec.  1.1061-
6(a)(2) to avoid any misperception that any office or bureau within the 
Treasury Department other than the IRS is responsible for examining 
taxpayers' returns.

E. Securities Partnerships

    The proposed regulations include an amendment to Sec.  1.704-3(e), 
which provides that a method for aggregating gains and losses by a 
securities partnership will not be considered reasonable unless it 
takes into account the application of section 1061. Specifically, the 
proposed regulations require partnerships that use the partial or full 
netting approaches described in Sec.  1.704-3(e) to establish accounts 
to track API Holders' Capital Interest Gains and Losses, Unrealized API 
Gains and Losses, and API Gains and Losses. A commenter questioned 
whether these rules were necessary, given the likelihood of hedge fund 
managers to leave a fund before the three-year holding period expires. 
Another commenter noted that funds would need to implement 
sophisticated tracking mechanisms to distinguish between Capital 
Interest Gains and Losses and API Gains and Losses. The commenter 
thought that such tracing conflicted with the principles of aggregation 
provided by Sec.  1.704-3(e).
    Another commenter recommended that the final regulations confirm 
that partnerships can change their section 704(c) aggregation method in 
order to address section 1061 in a manner consistent with the 
regulations and that any such change would not violate the requirement 
to use the same aggregation approach once an approach is adopted. The 
commenter requested that the final regulations provide examples 
illustrating the intended application of the creation of separate 
accounts for APIs and capital interests.
    The final regulations provide a simplified rule in Sec.  1.704-3(e) 
that states that section 1061 must be taken into account in applying 
the aggregation rule for securities partnerships, but does not provide 
a specific method for doing so. The Treasury Department and the IRS 
continue to study the comments received on this issue and may provide 
additional guidance in the future.

IV. Additional Areas Under Study

A. Section 1061(b) Exception

    Section 1061(b) provides that ``[t]o the extent provided by the 
Secretary, [section 1061(a)] shall not apply to income or gain 
attributable to any asset not held for portfolio investment on behalf 
of third party investors.'' The proposed regulations reserve with 
respect to the application of section 1061(b). The preamble to the 
proposed regulations states that the Treasury Department and the IRS 
generally believe that the section 1061(b) exception is effectively 
implemented in the proposed regulations with the exception to section 
1061 for Passthrough Interest Direct Investment Allocations. The 
preamble further requested comments on the application of section 
1061(b) and whether the proposed regulations' exclusion for Passthrough 
Interest Direct Investment Allocations properly implements the 
exception.
    One commenter suggested that the Passthrough Interest Direct 
Investment Allocations would exempt certain family offices from section 
1061(a) but stated that the exception is too narrow to account for all 
types of family offices. The commenter noted that section 1061(b) is 
not intended to cover family offices managed by a professional 
investment manager who is not a family member and who receives an API 
because the family members are third-party investors with respect to 
the professional investment manager. Several commenters suggested that 
additional guidance under section 1061(b) is needed for family offices, 
management companies, and other partnerships that do not hold assets 
for portfolio investment on behalf of third-party investors. One 
commenter argued

[[Page 5473]]

that the Treasury Department and the IRS should not reserve on section 
1061(b) because carried interests as used in asset management 
businesses were the particular focus of Congress as it contemplated 
carried interest proposals.
    One commenter noted that it had recommended prior to the issuance 
of the proposed regulations that the authority under section 1061(b) 
should be exercised to confirm that section 1061(a) does not apply to 
recharacterize income or gain attributable to the value of intangibles, 
including goodwill, created or used in an ATB. The commenter recognized 
that the Passthrough Interest Direct Investment Allocation rules in the 
proposed regulations operate in part to implement an exception for 
enterprise value, but recommended that final regulations should provide 
specifically that section 1061(a) does not apply to recharacterize 
income or gain attributable to enterprise value. Furthermore, the 
commenter argued that the enterprise value exception should apply to 
allocations through tiers and should not require allocations in 
accordance with partner capital accounts if the intangible asset it not 
held for portfolio investment on behalf of third-party investors.
    As discussed in Part II.A. of this Summary of Comments and 
Explanation of Revisions, the final regulations modify the rules 
related to the capital interest exception, including removing the 
Passthrough Interest Direct Investment Allocation rules. As discussed 
in Part II.C. of this Summary of Comments and Explanation of Revisions, 
the final regulations provide that the delayed holding period prong of 
the Lookthrough Rule does not apply to the disposition of an API to the 
extent that the gain recognized upon the disposition is attributable to 
any asset not held for portfolio investment on behalf of third party 
investors. The Treasury Department and the IRS continue to study the 
comments regarding section 1061(b) and may address the application of 
the provision in future guidance, including whether section 1061(a) 
applies to recharacterize income or gain attributable to enterprise 
value. The Treasury Department and the IRS request additional comments 
related to section 1061(b).

B. Small Partnerships

    In the preamble to the proposed regulations, the Treasury 
Department and the IRS requested comments and suggestions on whether a 
simplified method for determining and calculating the API Gain or Loss 
should be provided for small partnerships and if so, the criteria that 
should be used to determine which partnerships should be eligible to 
use the simplified method. One commenter stated that a small 
partnership exception is critically important to the integrity of the 
entire section 1061 regulatory regime. The commenter also noted that 
given the burdensome nature of the reporting requirements that could 
apply to small business taxpayers, a modification of these requirements 
for either ``small partnerships'' or ``small partners'' would appear to 
be justified. As discussed in the section on reporting requirements, a 
commenter also recommended a de minimis exception to the reporting 
requirements for passthrough entities in which a limited partner owns 
five percent, or less, of a fund. The Treasury Department and the IRS 
continue to study this issue and may address this in future guidance. 
The Treasury Department and the IRS request additional comments and 
suggestions on whether a simplified method for determining and 
calculating the API Gain or Loss should be provided for small 
partnerships and if so, the criteria that should be used to determine 
which partnerships should be eligible to use the simplified method.

V. Applicability Dates

    The final regulations retain the applicability dates as proposed. 
Accordingly, the final regulations generally apply to taxable years of 
Owner Taxpayers and Passthrough Entities beginning on or after January 
19, 2021. Section 1.1061-3(b)(2)(i) applies to taxable years beginning 
after December 31, 2017. Section 1.1061-3(b)(2)(ii) applies to taxable 
years beginning after August 14, 2020. An Owner Taxpayer or Passthrough 
Entity may choose to apply the final regulations in their entirety to a 
taxable year beginning after December 31, 2017, provided that they 
consistently apply the final regulations in their entirety to that year 
and all subsequent years.
    With respect to an API in a partnership with a fiscal year ending 
after December 31, 2017, section 706 determines the capital gains and 
losses the Owner Taxpayer includes in income with respect to an API 
after December 31, 2017. Section 706 provides that the taxable income 
of a partner for a taxable year includes amounts required by sections 
702 and 707(c) with respect to a partnership based on the income, gain, 
loss, deduction, or credit of a partnership for any taxable year ending 
within or with the taxable year of the partner. Accordingly, if a 
calendar year Owner Taxpayer has an API in a fiscal year partnership 
whose taxable year ends after December 31, 2017, section 1061 applies 
to the Owner Taxpayer's distributive share of long-term capital gain or 
loss with respect to the API in calendar year 2018 regardless of 
whether the partnership disposed of the property giving rise to the 
gains and losses in the period prior to January 1, 2018. See Sec.  
1.706-1(a).

Special Analyses

I. Regulatory Planning and Review--Economic Analysis

    Executive Orders 12866, 13563, and 13771 direct agencies to assess 
costs and benefits of available regulatory alternatives and, if 
regulation is necessary, to select regulatory approaches that maximize 
net benefits (including potential economic, environmental, public 
health and safety effects, distributive impacts, and equity). Executive 
Order 13563 emphasizes the importance of quantifying both costs and 
benefits, of reducing costs, of harmonizing rules, and of promoting 
flexibility.
    These regulations have been designated as economically significant 
under Executive Order 12866 pursuant to the Memorandum of Agreement 
(April 11, 2018) between the Treasury Department and the Office of 
Management and Budget (OMB) regarding review of tax regulations.

A. Need for Final Regulations

    These final regulations provide certainty and clarity to taxpayers 
affected by statutory changes introduced in section 1061 by TCJA. The 
Treasury Department and the IRS have received questions and comments 
regarding the meaning of various provisions in section 1061 and issues 
not explicitly addressed in the statute. The Treasury Department and 
the IRS have determined that such comments warrant the issuance of 
further guidance.

B. Background

    Section 1061 of the Internal Revenue Code (Code), enacted by TCJA, 
characterizes certain long-term capital gains recognized with respect 
to an API as short-term capital gains. Short-term capital gains are 
generally taxed at a higher rate than long-term capital gains.
    Section 1061 defines an API as an interest in a partnership 
transferred to or held by the taxpayer in connection with the 
performance of substantial services by the taxpayer, or any other 
related person, in any ``applicable trade or business'' (ATB). Under 
section 1061 the term ATB encompasses a range of financial service 
activities. Specifically, an ATB is any activity conducted on a 
regular, continuous, and substantial basis which consists, in whole or 
in

[[Page 5474]]

part, of raising or returning capital, and either (i) investing in (or 
disposing of) ``specified assets'' (or identifying specified assets for 
such investing or disposition), or (ii) developing specified assets. 
``Specified assets'' are certain securities, certain commodities, real 
estate held for rental or investment, cash or cash equivalents, options 
or derivative contracts with respect to any of the foregoing, and an 
interest in a partnership to the extent of the partnership's 
proportionate interest in any of the foregoing.
    Prior to the TCJA, the Internal Revenue Code made no distinction 
between capital gains allocated to APIs versus other partnership 
interests and partnership assets. Generally, the required holding 
period to obtain the lower long-term capital gains tax rate was one 
year for all partnership interests and partnership capital assets. 
Under the new provision, the required holding period for an API must be 
greater than three years to obtain long-term capital gains treatment.
    The Treasury Department and the IRS previously published proposed 
regulations under section 1061 (``proposed regulations'').

C. Overview of the Final Regulations

    The final regulations provide taxpayers with definitional and 
computational guidance regarding the application of section 1061. In 
particular, the final regulations provide a number of definitions, 
including the term `taxpayer' for the purpose of determining the 
existence of an API. Additionally, the regulations clarify the rules 
for certain exceptions to section 1061, including the exception for 
capital interests, and provide for an additional exception for bona 
fide purchases of APIs by an unrelated party who is not a service 
provider. The final regulations also provide rules for calculating the 
recharacterized gain amount.

D. Economic Analysis

1. Baseline
    In this analysis, the Treasury Department and the IRS assess the 
benefits and costs of the final regulations relative to a no-action 
baseline reflecting anticipated Federal income tax-related behavior in 
the absence of these final regulations.
2. Summary of Economic Effects
    The final regulations provide certainty and consistency in the 
application of section 1061 by providing definitions and clarifications 
regarding the statute's terms and rules. An economically efficient tax 
system generally aims to treat income and expense derived from similar 
economic decisions consistently across taxpayers and activities in 
order to reduce incentives for individuals and businesses to make 
choices based on tax rather than market incentives. In the absence of 
the guidance provided in these final regulations, taxpayers would bear 
the burden of interpreting the statute and the chances that different 
taxpayers might interpret the statute differently would be exacerbated. 
For example, two similarly situated taxpayers might interpret the 
statutory provisions pertaining to the definition of taxpayer or the 
capital interest exception differently, causing one to enter into a 
partnership that another comparable taxpayer might decline because of a 
different interpretation of how the income will be treated under 
section 1061. If this opportunity did not go to the more productive 
taxpayer, this lack of clarity results in an economically inefficient 
pattern of activity. An economic loss may also arise if all taxpayers 
have identical interpretations of the tax treatment of particular 
income streams under the statute but which differ slightly from the 
interpretation that Congress intended for these income streams. In this 
case, guidance provides value by bringing economic decisions closer in 
line with the intent and purpose of the statute.
    The final regulations include multiple substantive changes compared 
to the proposed regulations. The Treasury Department and the IRS view 
these changes as favorable to taxpayers, providing more flexibility and 
reducing burden and complexity. In particular, the final rules 
governing the capital interest exception are more flexible to better 
accommodate common business practices, which vary considerably across 
industries. Compared to the proposed regulations, the final regulations 
considerably narrow the range of related party transactions triggering 
1061 recharacterization, and the associated compliance burden. Finally, 
compared to the proposed regulations, the Lookthrough Rule on the sale 
of APIs included in the final regulations is a more narrowly targeted 
anti-abuse rule, only imposing a compliance burden on taxpayers that 
appear to have engaged in abusive practices with the primary aim of 
avoiding section 1061(a) recharacterization.
    The proposed regulations solicited comments on the economic 
analysis of the proposed regulations. No such comments were received.
3. Economic Analysis of Specific Provisions
a. Provisions Not Substantially Revised From the Proposed Regulations
i. Definition of Taxpayer
    The statute requires taxpayers to make a number of determinations, 
including the determination of the existence of an API, and the 
calculation of the section 1061 amount, or amount of long-term gain 
recharacterized under section 1061. However, the term ``taxpayer'' is 
not defined in either section 1061 or in the Conference Report. 
Comments received by the Treasury Department and IRS highlight the 
importance of the definition of the term taxpayer for purposes of 
section 1061. Without guidance, taxpayers could use different 
approaches to define ``taxpayer,'' leading otherwise similar taxpayers 
to experience different degrees of complexity, and to report different 
recharacterized amounts.
    The final regulations include two definitions of taxpayer to 
address the level at which the determination of the existence of an API 
is made and the level at which the calculation of the section 1061 
amount is made. The final regulations define the Owner Taxpayer as the 
person generally required to pay tax on the gain or loss with respect 
to the API. Under the final regulations, the section 1061 calculation 
is only performed by the person (the Owner Taxpayer) who must pay tax 
on the gains and losses recognized with respect to the API. The final 
regulations also introduce the term Passthrough Taxpayer. A Passthrough 
Taxpayer is an entity that does not itself generally pay tax on capital 
gains but must determine when an API exists and allocate income, gain, 
deduction and loss to its owners. Both the Owner Taxpayer and the 
Passthrough Taxpayer are treated as taxpayers for the purpose of 
determining whether an API exists.
    The Treasury Department and the IRS considered and rejected two 
alternative approaches to the definition of taxpayer outlined in 
received comments, the ``aggregate approach'' and the ``full entity 
approach''. Under the aggregate approach, a partnership is not treated 
as a taxpayer for purposes of section 1061. Instead, section 1061 is 
applied solely to the partners that are ultimately subject to tax on 
the partnership's items of capital gain and loss. A concern with using 
this approach for the purpose of determining whether an API exists is 
that it could incentivize partners to use tiered ownership structures 
to avoid section 1061 recharacterization. For example, an upper tier 
partnership may

[[Page 5475]]

receive an interest in a lower-tier fund in connection with the upper-
tier partnership's performance of services in an ATB. Partners of the 
upper-tier partnership may contend that they did not receive their 
interest in the upper-tier partnership in connection with the services 
performed by the upper-tier partnership. Stopping such avoidance 
strategies would require complex rules and potentially burdensome 
reporting requirements when tiered ownership structures are involved.
    Under the ``full entity approach'', the partnership is treated as a 
taxpayer for purposes of both determining the existence of an API and 
calculating the section 1061 recharacterization amount. Treating the 
partnership as a taxpayer for purposes of calculating the section 1061 
recharacterization amount was found to be more burdensome than the 
approach taken in the final regulations for three reasons. First, using 
the full entity approach for determining the section 1061 
recharacterization amount may lead to increased recharacterization of 
gains under section 1061 because individuals would not be able to net 
gains and losses across multiple APIs. Second, the administrative 
burden on both the taxpayer and the IRS would be increased in cases of 
tiered ownership. Under the full entity approach, a separate section 
1061 calculation would be required at each level at which an API is 
held in a tiered partnership structure. Finally, the full entity 
approach may add complexity and burden in cases in which an exception 
to section 1061 applies, such as if a corporation is a direct or 
indirect partner. Because corporations are excluded from section 1061, 
any amount recharacterized at the partnership level would need to be 
tracked as it is allocated to partners to ensure that corporate or 
other excepted partners are not subject to the three-year holding 
period under section 1061.
    The Treasury and the IRS have concluded that the chosen 
alternative, incorporating the concepts of Owner Taxpayer and 
Passthrough Taxpayer, is less burdensome than other alternatives and 
provides helpful certainty to taxpayers.
ii. Clarification of the Treatment of an API Purchased by an Unrelated 
Party
    The statute states that capital gain or loss recognized by a 
taxpayer on the sale of an API held for more than one year is subject 
to section 1061. The statute also provides guidance for ongoing 
treatment under section 1061 when the API is purchased by, or 
transferred to, a related party or another service provider. However, 
the statute does not provide guidance for the taxpayer who purchases an 
API and is neither a service provider to the relevant ATB, nor related 
to the seller of the API. The final regulations add an exception to 
section 1061 and provide that the term API does not include an interest 
in a partnership that would be treated as an API but is held by a bona 
fide purchaser of the interest who does not currently and has never 
provided services in the relevant ATB and who is not related to a 
person who provides services currently or has provided services in the 
past. By clarifying the treatment of an API that is sold at arm's 
length, the final regulations reduce uncertainty and compliance burdens 
for taxpayers entering into these transactions. The Treasury Department 
and the IRS have determined that this exception is consistent with the 
purpose of section 1061, which applies to service providers and persons 
related to service providers and which is not meant to apply to bona 
fide purchasers of a partnership interest who do not provide services.
    The Treasury Department and the IRS considered not providing this 
exception. However, it was determined that failure to provide this 
exception would treat unrelated purchasers of an API in an inequitable 
fashion, and that continued treatment of the partnership interest as an 
API would be inconsistent with the purpose of section 1061 because 
unrelated purchasers did not receive their interest in connection with 
the performance of substantial services.
b. Provisions Substantially Revised From the Proposed Regulations
i. Capital Interest Exception
    Section 1061(c)(4)(B) provides that the definition of an API does 
not include ``any capital interest in the partnership which provides 
the taxpayer with a right to share in partnership capital commensurate 
with--(i) the amount of capital contributed (determined at the time of 
receipt of such partnership interest) or (ii) the value of the interest 
included in income under section 83 upon the receipt or vesting of such 
interest.'' However, the statute does not provide guidance on what it 
means for a right to share in partnership capital to be 
``commensurate'' with the amount of capital contributed.
    The final regulations clarify that allocations are deemed 
commensurate with capital contributed if, under the partnership 
agreement, the allocation to an API Holder is calculated in a similar 
manner as the allocations to similarly situated Unrelated Non-Service 
Partners. This may be determined on an investment-by-investment or 
class-by-class basis. To qualify as a benchmark for comparison, the 
Unrelated Non-Service Partners must hold a significant investment, 
defined as at least five percent of the partnership. In the absence of 
these regulations, taxpayers might face confusion, along with 
substantial compliance cost, in calculating their qualifying capital 
interest. Further, partners with realized gains would be incentivized 
to engage in a series of inefficient transactions in order to minimize 
tax.
    The Treasury Department and the IRS considered alternative 
interpretations of ``commensurate with capital contributed.'' In 
particular, the proposed regulations provide that an allocation is 
``commensurate with capital'' if the allocation is based on the 
relative section 704(b) capital accounts of the partners under the 
partnership agreement. The proposed regulations then provide multiple 
rules for calculating an API holder's capital account, including a rule 
disallowing unrealized API capital gains in calculating the API 
holder's capital account, and a rule for determining the capital 
account when an API is held through another partnership. In light of 
numerous comments, the Treasury Department and the IRS have determined 
that the proposed regulations were too rigid and were not well suited 
to the wide variety of common business practices regarding ownership 
structure, accounting conventions, and compensation arrangements. 
Specifically, many partnerships subject to section 1061 do not maintain 
section 704(b) capital accounts. For many other partnerships, the 
capital account of one partner may relate to economic rights associated 
with multiple separate investments held by a partnership, while the 
capital account of another partner may relate to economic rights 
associated with a separate set of investments held by a partnership. 
For these reasons, the Treasury Department and the IRS have determined 
that the section 704(b) capital accounts of partners provide a poor 
means of measuring commensurate economic capital interest rights.
    The proposed regulations also prohibited use of the capital 
interest exception if a capital contribution was funded with related 
party loan proceeds. Commenters noted that it is a common business 
practice in industries subject to Section 1061 for employees to require 
new partners to make substantial capital contributions, which are often 
acquired through a loan. This arrangement, designed not to avoid tax 
but to align the incentives of general

[[Page 5476]]

partners and limited partners, would be unduly penalized under the 
proposed regulations, incentivizing firms to choose a less efficient 
ownership and governance structure. The final regulations amend the 
rule to allow an individual service provider's capital contributions to 
be funded with loan proceeds from partners and persons related to 
partners if the individual service provider is personally liable for 
the loan, meaning the loan is fully recourse to the individual service 
provider, the individual service provider has no right to be reimbursed 
by any person, and no person has guaranteed the individual service's 
provider's loan. The Treasury Department and the IRS believe the final 
rules address abusive avoidance strategies, while imposing less burden 
on taxpayers engaged in standard business practices relative to not 
allowing any contributions from proceeds from related part loans to be 
eligible for the capital interest exception.
ii. Lookthrough Rule on Sale of APIs
    Section 1061(a) provides that if one or more APIs are held by a 
taxpayer at any time during the taxable year, the excess (if any) of 
(1) the taxpayer's net long-term capital gain with respect to such 
interests for such taxable year, over (2) the taxpayer's net long-term 
capital gain with respect to such interests for that taxable year 
computed by applying paragraphs (3) and (4) of sections 1222 by 
substituting ``3 years'' for ``1 year,'' must be treated as short-term 
capital gain, notwithstanding section 83 or any election in effect 
under section 83(b). The House Report explains that section 1061 
``imposes a three-year holding period (not the generally applicable 
one-year holding period) in the case of long-term capital gain from 
applicable partnership interests.'' Neither section 1061 nor the 
Reports, however, explicitly provides what the relevant holding period 
is for purposes of section 1061(a) for the sale of an API with assets 
of different holding periods.
    The final regulations include a Lookthrough Rule that is triggered 
if a transaction or series of transactions has taken place with a 
principal purpose of avoiding potential gain recharacterization under 
section 1061(a). Under this Lookthrough Rule, all gain not attributable 
to assets held for more than three years is subject to 
recharacterization under section 1061(a). Additionally, the Lookthrough 
Rule applies if the API disposition would be subject to Section 1061(a) 
recharacterization using a holding period not beginning until the date 
that Unrelated Non-Service Partners legally commit to contribute 
substantial capital to the applicable partnership. Without this rule, 
fund managers might attempt to avoid the recharacterization of gains by 
establishing partnerships and leaving them inactive for three years 
before attracting investment from limited partners, thereby 
circumventing Section 1061.
    The Treasury Department and the IRS considered and rejected 
alternative approaches, including applying a simple interest approach, 
an alternative lookthrough rule (as provided in the proposed 
regulations), and an underlying assets approach. The simple interest 
approach looks solely to the holding period in the API, regardless of 
the length of time the partnership has engaged in substantive 
investment. This approach might allow taxpayers to avoid section 1061 
characterization for long-term capital gains on assets that are not 
held for the more than three years by the partnership. This result 
would encourage distortive behavior in investment funds, which might 
look to create partnerships for different investors solely for tax 
purposes, relative to the approach adopted in the final regulations. 
That is, the partners of that investment partnership would not be 
subject to section 1061 if they had owned their APIs for more than 
three years, irrespective of how long the investment partnership had 
been active and attracting capital from outside investors.
    Alternatively, the underlying asset, or full lookthrough, approach 
looks solely to the holding period in the underlying asset (or assets) 
of the partnership, regardless of whether the underlying asset is sold 
by the partnership or the API is sold by its owner. The underlying 
asset approach would be more difficult (and burdensome) for taxpayers 
to apply (relative to the provision provided in the final regulations) 
as it would require a determination of the unrealized gain for each 
asset held by the partnership, even in cases in which a relatively 
small share of assets by value have a holding period of three years or 
less.
    The proposed regulations included an alternative lookthrough rule 
applied to the sale of an API if 80% or more of the value of the assets 
held by the partnership at the time of the API disposition were assets 
held for three years or less that would produce capital gain or loss 
subject to section 1061 if disposed of by the partnership. If the 
lookthrough rule in the proposed regulations applied, a portion of the 
capital gain on the disposition of the API attributable partnership 
assets held for three or fewer years would be recharacterized as short-
term capital gain. This alternative was rejected in the final 
regulations because the calculations required by the proposed 
lookthrough rule would impose unnecessary compliance burden on 
individual taxpayers selling an API without any accompanying general 
economic benefit. The rules requiring partnerships to furnish taxpayers 
with the relevant information to perform the calculations would also 
impose undue additional burden on the relevant partnerships. The 
lookthrough rule provided in the final regulations applies in more 
limited circumstances, narrowly targeting taxpayers that appear to be 
engaged in abusive practices to avoid section 1061(a) 
recharacterization. Therefore, the final regulations provide helpful 
guidance and certainty for taxpayers, while imposing minimal compliance 
burden relative to the no-action baseline or alternative regulatory 
approaches.
iii. Treatment of API Transfers to Related Parties
    Section 1061(d) recharacterizes certain long-term capital gain as 
short-term capital gain when a taxpayer transfers an API to a related 
person. While the statute provides a definition of a related person and 
a general description of the recharacterization amount, numerous 
commenters expressed uncertainty regarding the scope of transfers 
subject to section 1061(d), pointing out that although the statutory 
language of section 1061(d) refers to the transfer of an API, it refers 
to income inclusion associated with an API transfer that is related to 
the sale or exchange of partnership assets held for three years of 
less. Based on the statutory language, commenters expressed the view 
that section 1061(d) transfers should be limited to taxable transfers.
    Although one read of the text of section 1061(d) suggests that the 
provision can be broadly applied to capture all API transfers, 
including gifts and other nonrecognition transfer, the Treasury 
Department and the IRS considered and rejected applying section 1061(d) 
to nontaxable transfers. Applying section 1061(d) to nontaxable 
transfers would impose income recognition on gifts including an API, 
where no income recognition is imposed on otherwise similar gifts, 
creating a tax disadvantage for gifts including an API. Instead, the 
Treasury and the IRS have determined that the section 1061(d) statute 
is better read as a recharacterization provision that looks to how much 
of the taxpayer's long-term capital gain upon the sale of an API is

[[Page 5477]]

attributable to the sale or exchange of any asset held for three years 
or less and that the provision's use of the word ``transfer'' does not 
supersede application of the sale or exchange requirement in the 
statute.

II. Paperwork Reduction Act

A. Collection of Information in Sec.  1.1061-6(a) on the Owner Taxpayer 
is on Existing Forms

    The collection of information in Sec.  1.1061-6(a) requires an 
Owner Taxpayer to file such information with the IRS as the 
Commissioner may require in forms, instructions and other published 
guidance as is necessary for the IRS to determine that the taxpayer has 
properly complied with section 1061 and the Section 1061 Regulations. 
This information is necessary for the IRS to determine that the Owner 
Taxpayer has properly complied with section 1061. In general, the Owner 
Taxpayer is an individual and the Owner Taxpayer's Recharacterization 
Amount and Section 1061(d) Recharacterization Amount will be required 
to be reported to the IRS as short-term capital gain on Schedule D, 
``Capital Gains and Losses,'' of the Form 1040, ``U.S. Individual 
Income Tax Return.'' Less frequently, the Owner Taxpayer is a trust and 
the Owner Taxpayer's Recharacterization Amount and Section 1061(d) 
Recharacterization Amount will be required to be reported to the IRS as 
short-term capital gain on Schedule D, ``Capital Gains and Losses,'' of 
the Form 1041, ``U.S. Income Tax Return for Estates and Trusts.''
    The current status of the Paperwork Reduction Action submission 
related to Sec.  1.1061-6(a) is provided in the following table. The 
burdens associated with the collection of information from the Owner 
Taxpayer to comply with section 1061 are included in the aggregate 
burden estimates for Form 1040 under OMB control number 1545-0074 and 
Form 1041 under OMB control number 1545-0092. The overall burden 
estimates provided in OMB Control Number 1545-0074 represents a total 
estimated burden time, including all other related forms and schedules 
for individuals, of 1.784 billion hours and total estimated monetized 
costs of $31.74 billion (in 2017 dollars). The overall burden estimates 
provided in OMB Control Number 1545-0092 represents a total estimated 
burden time, including all other forms and schedules for trusts and 
estates of 307.8 million hours and total estimated monetized costs of 
$9.95 billion (in 2016 dollars). These amounts are aggregate amounts 
that relate to all information collections associated with the 
applicable OMB control numbers, and will in the future include, but not 
isolate, the estimated burden of Owner Taxpayers as a result of the 
information collections in the regulations. No burden estimates 
specific to the final regulations are currently available. The Treasury 
Department and IRS have not estimated the burden, including that of any 
new information collections, related to the requirements under the 
final regulations. Those estimates would capture both changes made by 
the TCJA and those that arise out of discretionary authority exercised 
in the regulations. The Treasury Department and the IRS request 
comments on all aspects of information collection burdens related to 
the collection of information applicable to the Owner Taxpayer in these 
regulations. In addition, when available, drafts of IRS forms are 
posted for comment at www.irs.gov/draftforms.

----------------------------------------------------------------------------------------------------------------
                 Form                         Type of filer          OMB No.(s)                Status
----------------------------------------------------------------------------------------------------------------
Form 1040 (Including Schedule D)......  Individual (NEW Model)...       1545-0074  Published in the Federal
                                                                                    Register on 9/30/19. Comment
                                                                                    period closed on 11/29/19.
                                                                                    84 FR 51712. Thirty-day
                                                                                    notice published on 12/18/
                                                                                    19. 84 FR 69458. Approved by
                                                                                    the Office of Information
                                                                                    and Regulatory Affairs
                                                                                    (OIRA) on 1/30/20.
Form 1041 (Including Schedule D)......  Trusts and Estates              1545-0092  Published in the Federal
                                         (Legacy Model).                            Register on 4/4/2018. 83 FR
                                                                                    14552. Public comment period
                                                                                    closed 6/4/2018. Thirty-day
                                                                                    notice published on 9/27/18.
                                                                                    83 FR 48894. Approved by
                                                                                    OIRA on 5/8/19.
----------------------------------------------------------------------------------------------------------------

B. Collection of Information on Passthrough Entities in Sec.  1.1061-
6(b) and (c) on Existing Forms

1. Passthrough Entities
    The collection of information in Sec.  1.1061-6(b) requires a 
Passthrough Entity that has issued an API to furnish to the API Holder, 
including the Owner Taxpayer, such information at such time and in such 
manner as the Commissioner may require in forms, instructions, and 
other published guidance as is necessary to determine the One Year Gain 
amount and the Three Year Gain Amount with respect to an Owner 
Taxpayer. This includes: (i) The API One Year Distributive Share Amount 
and the API Three Year Distributive Share Amount (as determined under 
Sec.  1.1061-4); (ii) Capital gains and losses allocated to the API 
Holder that are excluded from section 1061 under Sec.  1.1061-4(b)(7); 
(iii) Capital Interest Gains and Losses allocated to the API Holder (as 
determined under Sec.  1.1061-3(c)); (iv) In the case of a disposition 
by the API Holder of an interest in the Passthrough Entity during the 
taxable year, any information required by the API Holder to properly 
take the disposition into account under section 1061, including 
information necessary to apply the Lookthrough Rule and to determine 
its Capital Interest Disposition Amount and any information necessary 
to determine an Owner Taxpayer's Section 1061(d) Recharacterization 
Amount. The regulations seek to minimize the information that a 
Passthrough Entity is required to automatically furnish annually. In 
some cases, an upper-tier Passthrough Entity may be an API Holder in a 
lower-tier Passthrough Entity, and the information furnished by the 
lower-tier Passthrough Entity to the upper-tier Passthrough Entity may 
not be sufficient for the upper-tier Passthrough Entity to meet its 
reporting obligations under the regulations. In this case, the 
regulations require the lower-tier Passthrough Entity to furnish 
information to the upper-tier Passthrough Entity if requested. Thus, if 
an upper-tier Passthrough Entity in a tiered entity structure holds an 
interest in a lower-tier Passthrough Entity and it needs information 
from the lower-tier Passthrough Entity to comply with its obligation to 
furnish information under the regulations, it must request information 
from the lower-tier entity and the lower-tier entity must furnish the 
requested information. This passing of information upon request between 
the tiers of entities is necessary to minimize the quantity of 
information required to be annually furnished by a Passthrough Entity 
and because each Passthrough Entity in a tiered entity arrangement is 
the only entity that has

[[Page 5478]]

access to the information that is required to be furnished. The 
collection of information in the regulations is necessary to ensure 
that the Owner Taxpayer receives information sufficient to correctly 
calculate its Recharacterization Amount under section 1061.
2. RICs and REITs
    Section 1.1061-6(c) permits a RIC or a REIT that reports or 
designates all or a part of a dividend as a capital gain dividend, to 
disclose additional information to their shareholders for purposes of 
section 1061. The furnishing of this information may allow a 
Passthrough Entity to include a portion of the capital gain dividend in 
the API Three Year Distributive Share amount furnished to API Holders 
and may ultimately enable an Owner Taxpayer to reduce its 
Recharacterization Amount under the regulations.
3. Table for Collections of Information in Sec.  1.1061-6(b) and (c)
    The collection of information with respect to Sec.  1.1061-6(b) and 
(c) is provided in the following table. In the case of a Passthrough 
Entity that is a partnership, the information will be required to be 
furnished as an attachment to the Schedule K-1, ``Partner's Share of 
Income, Deduction, Credit, Etc.'' of Form 1065, ``U.S. Return of 
Partnership Income.'' In the case of a Passthrough Entity that is an S 
corporation, the information will be required to be furnished as an 
attachment to the Schedule K-1, ``Shareholder's Share of Income, 
Deductions, Credit, Etc.,'' of Form 1120-S, ``U.S. Income Tax Return 
for an S Corporation.'' The burdens associated with the collection of 
information from the Passthrough Entities will be included in the 
aggregate burden estimates for the Form 1065 and the Form 1120S under 
OMB control number 1545-0123. The overall burden estimates provided in 
OMB Control Number 1545-0123 represents a total estimated burden time, 
including all others related forms and schedules, of 3.344 billion 
hours and total estimated monetized costs of $61.558 billion (in 2019 
dollars). The burden estimates provided in OMB Control Number 1545-0123 
are aggregate amounts that relate to all information collections 
associated with the applicable OMB control number, and will in the 
future include, but not isolate, the Passthrough Entities' estimated 
burden as a result of the information collections in the proposed 
regulations.
    In the case of a Passthrough Entity that is a trust or estate, the 
information will be required to be furnished as an attachment to the 
Schedule K-1, ``Beneficiary's Share of Income, Deductions, Credit, 
Etc.,'' of Form 1041, ``U.S. Income Tax Return for Estates and 
Trusts.'' The burdens associated with the collection of information 
from a Passthrough Entity that is a trust or estate will be included in 
the aggregate burden estimates for the Form 1041 OMB control number 
1545-0092. The overall burden estimates provided in OMB Control Number 
1545-0092 represents a total estimated burden time, including all other 
forms and schedules for trusts and estates of 307.8 million hours and 
total estimated monetized costs of $9.95 billion (in 2016 dollars). The 
burden estimates provided in OMB Control Number 1545-0092 are aggregate 
amounts that relate to all information collections associated with the 
applicable OMB control number, and will in the future include, but not 
isolate, the Passthrough Entities' estimated burden as a result of the 
information collections in the regulations.
    In the case of RICs and REITs the information will be furnished in 
connection with the Form 1099-DIV, ``Dividends and Distributions.'' The 
burden estimates associated with the collection of information from 
RICs and REITs will be included in the aggregate burden estimated for 
the Form 1099-DIV under OMB Control Number 1545-0110. The overall 
burden estimates provided in OMB Control Number 1545-0110 represents a 
total estimated burden time of 32,119,195 hours and total estimated 
monetized costs of $ 1.64 billion (in 2016 dollars). The burden 
estimates provided in OMB Control Number 1545-0110 relate to all 
information collections associated with the applicable OMB Control 
Number, and will in the future include, but not isolate, the RIC and 
REIT estimated burden as a result of the information collections in the 
regulations.
    The Treasury Department and IRS have not estimated the burden, 
including that of any new information collections, related to the 
requirements under the regulations. Those estimates would capture both 
changes made by the TCJA and those that arise out of the discretionary 
authority exercised in the regulations. The Treasury Department and the 
IRS request comments on all aspects of information collection burdens 
related to the collection of information applicable to the Passthrough 
Entities in the regulations. In addition, when available, drafts of IRS 
Forms and the applicable instructions are posted for comment at https://www.irs.gov/pub/irs-dft/.

----------------------------------------------------------------------------------------------------------------
                 Form                         Type of filer          OMB No.(s)                Status
----------------------------------------------------------------------------------------------------------------
Form 1041 (including Schedule K-1)....  Trusts and Estates              1545-0092  Published in the Federal
                                         (Legacy Model).                            Register on 4/4/2018. 83 FR
                                                                                    14552. Public comment period
                                                                                    closed 6/4/2018. Thirty-day
                                                                                    notice published on 9/27/18.
                                                                                    83 FR 48894. Approved by
                                                                                    OIRA on 5/8/19.
Form 1065 (including Schedule K-1)....  Business (NEW Model).....       1545-0123  Sixty-day notice published in
                                                                                    the Federal Register on 9/30/
                                                                                    19. Public Comment period
                                                                                    closed on 11/29/19. 84 FR
                                                                                    51718. Thirty-day notice
                                                                                    published in the Federal
                                                                                    Register on 12/19/19. Public
                                                                                    Comment period closed on 1/
                                                                                    21/20. 84 FR 69825. Approved
                                                                                    by OIRA on 1/30/20.
Form 1120S (Including Schedule K-1)...  Business (New Model).....       1545-0123  Sixty-day notice published in
                                                                                    the Federal Register on 9/30/
                                                                                    19. Public Comment period
                                                                                    closed on 11/29/19. 84 FR
                                                                                    51718. Thirty-day notice
                                                                                    published in the Federal
                                                                                    Register on 12/19/19. Public
                                                                                    Comment period closed on 1/
                                                                                    21/20. 84 FR 69825. Approved
                                                                                    by OIRA on 1/30/20.
Form 1099-DIV.........................  (Legacy Model)...........       1545-0110  Sixty-day notice published in
                                                                                    the Federal Register on 9/19/
                                                                                    19. Public comment period
                                                                                    closed 11/18/19. 84 FR
                                                                                    49379. Thirty-day notice
                                                                                    published in the Federal
                                                                                    Register on 12/20/19. 84 FR
                                                                                    70269.
                                       -------------------------------------------------------------------------

[[Page 5479]]

 
                                        Link: https://www.federal register.gov/documents/2018/05/23/2018-10981/proposed-collection-comment-request-for-form-1099-div.
----------------------------------------------------------------------------------------------------------------

C. Chart Showing Number of Respondents Regarding Existing Forms

    The following chart shows the estimated number of returns that are 
expected to have attachments providing additional information with 
respect to section 1061. As noted previously, Owner Taxpayers will be 
required to provide section 1061 information on an attachment to 
Schedules D for Forms 1040 and 1041. Passthrough Taxpayers will be 
required to report section 1061 on Forms 1041, 1065, and 1120S to the 
IRS and to furnish information to their API Holders on attachments to 
the respective K-1s. RICs and REITs may voluntarily report additional 
information at an attachment to Form 1099-DIV.

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Schedule D Form 1040....................................          20,475
Schedule D Form 1041....................................           2,275
Schedule K Form 1065....................................          28,500
Schedule K-1s Form 1065.................................          57,000
Schedule K Form 1120S...................................           1,500
Schedule K-1s Form 1120.................................           1,000
Form 1099-DIV filed by REITs............................             836
Form 1099-DIV filed by RICs.............................           3,880
------------------------------------------------------------------------

D. Voluntary Collection of Information in Sec.  1.1061-6(d) on PFIC 
Shareholder Will Be Added to Existing OMB Control Number for PFIC 
Information Retention

    Section 1.1061-6(d) permits a PFIC with respect to which the 
shareholder is an API Holder who has a QEF election is in effect for 
the taxable year to provide additional information to the shareholder 
to determine the amount of the shareholder's inclusion that would be 
included in the API One Year Distributive Share Amount and the API 
Three Year Distributive Share Amount. If the PFIC furnishes this 
information to the shareholder, the shareholder must retain a copy of 
this information along with the other information required to be 
retained under Sec.  1.1295-1(f)(2)(ii). The burden associated with 
retaining this additional information will be included in the aggregate 
burden estimates for Sec.  1.1295-1(f) under OMB Control Number 1545-
1555. An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information unless it displays 
a valid control number assigned by the Office of Management and Budget.
    Books and records related to the collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

III. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that these final regulations will not have a 
significant economic impact on a substantial number of small entities 
within the meaning of section 601(6) of the Regulatory Flexibility Act. 
These regulations generally only impact investment funds that have 
capital gains and losses that derive from the disposition of assets 
that have a holding period of more than one year but not more than 
three years. Investment funds are considered small business if they 
have annual average receipts of $41.5 million or less (13 CFR part 
121). The rule may affect a substantial number of small entities, but 
data are not readily available to assess how many entities will be 
affected.
    The Treasury Department and the IRS received no actionable comments 
on the impact that the proposed regulations would have on small 
entities. Although certain commenters requested that partnerships with 
an unspecified amount of limited assets be excepted from the 
application of the statutory rules of section 1061, these commenters 
did not provide any data to demonstrate that any burden would be 
significant. Similarly, a commenter requested an exception to the 
reporting requirements for passthrough entities in which a limited 
partner owns 5 percent or less of a fund but did not quantify the 
burden. In addition, the final regulations adopt other comments that 
limit the general burden of the regulations to all entities, including 
small entities.
    Even if a substantial number of small entities are affected, the 
economic impact of these regulations on small entities is not 
significant. The regulations provide taxpayers with definitional and 
computational guidance regarding the application of section 1061. The 
impact of the regulations is to impose an additional reporting 
obligation that applies only with respect to the sale of assets held 
for more than one year but not more than three years. The Treasury 
Department and the IRS recognize that this reporting obligation may 
increase, at least to some extent, the tax preparation burden for 
affected taxpayers beyond that imposed by the statute. This reporting 
obligation generally will only apply to a minority of the asset 
dispositions by an entity. The entity will also have a reporting 
obligation in certain circumstances regarding the disposition of an 
API, but the extent of the reporting obligation depends on the number 
of assets disposed by the entity and their holding periods. The 
information reported is readily available to taxpayers and reported on 
forms already in use beginning with the 2019 taxable year such as 
Schedule D to IRS Form 1065. Finally, some taxpayers may find they need 
an initial investment of time to read and understand these regulations 
at an approximate cost of $95/hour and an estimated time of ten hours. 
Accordingly, the Secretary certifies that these regulations will not 
have a significant economic impact on a substantial number of small 
entities.
    Pursuant to section 7805(f), the notice of proposed rulemaking 
preceding this regulation was submitted to the Chief Counsel for the 
Office of Advocacy of the Small Business Administration for comment on 
its impact on small businesses. No comments were received from the 
Chief Counsel for the Office of Advocacy of the Small Business 
Administration.

IV. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 requires 
that agencies assess anticipated costs and benefits and take certain 
other actions before issuing a final rule that includes any Federal 
mandate that may result in expenditures in any one year by a state, 
local, or tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. This rule does not include any Federal mandate that may 
result in expenditures by state, local, or tribal governments, or by 
the private sector in excess of that threshold.

V. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on

[[Page 5480]]

state and local governments, and is not required by statute, or 
preempts state law, unless the agency meets the consultation and 
funding requirements of section 6 of the Executive order. This rule 
does not have federalism implications and does not impose substantial 
direct compliance costs on state and local governments or preempt state 
law within the meaning of the Executive order.

VI. Congressional Review Act

    The Administrator of the Office of Information and Regulatory 
Affairs of the Office of Management and Budget has determined that this 
Treasury decision is a major rule for purposes of the Congressional 
Review Act (5 U.S.C. 801 et seq.). Under 5 U.S.C. 801(a)(3), a major 
rule takes effect 60 days after the rule is published in the Federal 
Register.
    Notwithstanding this requirement, 5 U.S.C. 808(2) allows agencies 
to dispense with the requirements of 5 U.S.C. 801 when the agency for 
good cause finds that such procedure would be impracticable, 
unnecessary, or contrary to the public interest and the rule shall take 
effect at such time as the agency promulgating the rule determines. 
Pursuant to 5 U.S.C. 808(2), the Treasury Department and the IRS find, 
for good cause, that a 60-day delay in the effective date is contrary 
to the public interest.
    Following the enactment of section 1061 by the TCJA, the Treasury 
Department and the IRS published the proposed regulations to provide 
certainty to taxpayers. In particular, as demonstrated by the wide 
variety of public comments in response to the proposed regulations 
received, taxpayers continue to express uncertainty regarding the 
proper application of the statutory rules under section 1061. This is 
especially the case for taxpayers in the trade or business of operating 
investment funds, which may be unwilling to engage in certain 
commercial transactions without the additional clarity provided by 
these final regulations. Additionally, various rules contained within 
these regulations attempt to curb certain abusive transactions designed 
to avoid the application of section 1061 and an earlier effective date 
is necessary to address these abusive transactions. Accordingly, the 
Treasury Department and the IRS have determined that the rules in this 
Treasury decision will take effect on the date of filing for public 
inspection in the Federal Register.

Statement of Availability of IRS Documents

    Notice 2018-18, 2018-2 I.R.B. 443 (in addition to any other revenue 
procedures or revenue rulings, etc. cited in this preamble) is 
published in the Internal Revenue Bulletin (or Cumulative Bulletin) and 
is available from the Superintendent of Documents, U.S. Government 
Publishing Office, Washington, DC 20402, or by visiting the IRS website 
at https://www.irs.gov.

Drafting Information

    The principal authors of these regulations are Kara K. Altman, 
Sonia K. Kothari, and Wendy L. Kribell of the Office of Associate Chief 
Counsel (Passthroughs and Special Industries). However, other personnel 
from the Treasury Department and the IRS participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendment to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries for Sec. Sec.  1.1061-0, 1.1061-1, 1.1061-2, 1.1061-3, 1.1061-
4, 1.1061-5, and 1.1061-6 in numerical order to read in part as 
follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.1061-0 added under 26 U.S.C. 1061(f).
    Section 1.1061-1 added under 26 U.S.C. 1061(f).
    Section 1.1061-2 added under 26 U.S.C. 1061(f).
    Section 1.1061-3 added under 26 U.S.C. 1(h)(9) and 1061(f).
    Section 1.1061-4 added under 26 U.S.C. 1061(f).
    Section 1.1061-5 added under 26 U.S.C. 1061(f).
    Section 1.1061-6 added under 26 U.S.C. 1061(f).
* * * * *

0
Par. 2. Section 1.702-1 is amended by adding a sentence at the end of 
paragraph (a)(2) and adding paragraph (g) to read as follows.


Sec.  1.702-1   Income and credits of partner.

    (a) * * *
    (2) * * * Each partner subject to section 1061 must take into 
account gains and losses from sales of capital assets held for more 
than one year as provided in section 1061 and Sec. Sec.  1.1061-1 
through 1.1061-6.
* * * * *
    (g) Applicability date. The last sentence of paragraph (a)(2) of 
this section applies for the taxable years beginning on or after 
January 19, 2021.

0
Par. 3. Section 1.704-3 is amended by:
0
1. In paragraph (e)(3)(vi)(B), remove the word ``and'' at the end of 
the paragraph;
0
2. Redesignating paragraph (e)(3)(vi)(C) as paragraph (e)(3)(vi)(D);
0
3. Adding new paragraph (e)(3)(vi)(C); and
0
4. Revising the heading and first sentence of paragraph (f) and adding 
a sentence to the end of paragraph (f).
    The additions and revisions read as follows:


Sec.  1.704-3   Contributed property.

* * * * *
    (e) * * *
    (3) * * *
    (vi) * * *
    (C) With respect to any person who directly or indirectly holds an 
Applicable Partnership Interest, as defined in Sec.  1.1061-1(a)(1), 
take into account the application of section 1061 with respect to such 
interest in an appropriate manner; and
* * * * *
    (f) Applicability dates. With the exception of paragraphs (a)(1), 
(a)(8)(ii) and (iii), (a)(10) and (11), and (e)(3)(vi)(C) of this 
section, and of the last sentence of paragraph (d)(2) of this section, 
this section applies to properties contributed to a partnership and to 
revaluations pursuant to Sec.  1.704-1(b)(2)(iv)(f) or (s) on or after 
December 21, 1993.
    * * * Paragraph (e)(3)(vi)(C) of this section applies to taxable 
years beginning on or after January 19, 2021.
* * * * *

0
Par. 4. Sections 1.1061-0 through 1.1061-6 are added before the 
undesignated center heading ``Changes to Effectuate F.C.C. Policy'' to 
read as follows:

Sec.
* * * * *
1.1061-0 Table of contents.
1.1061-1 Section 1061 definitions.
1.1061-2 Applicable partnership interests and applicable trades or 
businesses.
1.1061-3 Exceptions to the definition of an API.
1.1061-4 Section 1061 computations.
1.1061-5 Section 1061(d) transfers to related persons.
1.1061-6 Reporting rules.
* * * * *


Sec.  1.1061-0  Table of contents.

    This section lists the captions that appear in Sec. Sec.  1.1061-1 
through 1.1061-6.


[[Page 5481]]


Sec.  1.1061-1 Section 1061 definitions.

    (a) Definitions.
    (b) Applicability date.

Sec.  1.1061-2 Applicable partnership interests and applicable 
trades or businesses.

    (a) API rules and examples.
    (1) Rules.
    (i) An API remains an API.
    (ii) Application of section 1061 to Unrealized API Gains and 
Losses.
    (iii) API Gains and Losses retain their character.
    (iv) Substantial services by the Owner Taxpayer, Passthrough 
Taxpayer or any Related Person.
    (v) Grantor trusts and entities disregarded as separate from 
their owners.
    (2) Examples.
    (b) Application of the ATB Activity Test.
    (1) In general.
    (i) Rules for applying the ATB Activity Test.
    (A) Aggregate Specified Actions taken into account.
    (B) Raising or Returning Capital Actions and Investing or 
Developing Actions are not both required to be taken in each taxable 
year.
    (C) Combined conduct by multiple related entities taken into 
account.
    (ii) Developing Specified Assets.
    (iii) Partnerships.
    (2) Examples.
    (c) Applicability date.

Sec.  1.1061-3 Exceptions to the definition of an API.

    (a) A partnership interest held by an employee of another entity 
not conducting an ATB.
    (b) Partnership interest held by a corporation.
    (1) In general.
    (2) Treatment of interests held by an S corporation or a 
qualified electing fund.
    (c) Capital Interest Gains and Losses.
    (1) In general.
    (2) Capital Interest Gains and Losses defined.
    (3) General rules for determining Capital Interest Allocations.
    (i) Commensurate with capital contributed.
    (ii) In a similar manner.
    (A) Relevant factors.
    (B) Clear identification requirement.
    (iii) Reinvestment of API Gain.
    (iv) Unrelated Non-Service Partner requirement.
    (v) Proceeds of certain loans not taken into account for Capital 
Interest Allocation purposes.
    (A) General rule.
    (B) Recourse liability.
    (vi) Items that are not included in Capital Interest 
Allocations.
    (4) Capital Interest Disposition Amounts.
    (i) In general.
    (ii) Determination of the Capital Interest Disposition Amount.
    (5) Capital Interest Allocations made by a Passthrough Entity 
that is an API Holder.
    (6) Examples.
    (d) Partnership interest acquired by purchase by an unrelated 
person.
    (1) Acquirer not a Related Person.
    (2) Section 1061(d) not applicable.
    (3) Acquirer not a service provider.
    (e) [Reserved]
    (f) Applicability date.
    (1) General rule.
    (2) Partnership interest held by an S corporation.
    (3) Partnership interest held by a PFIC with respect to which 
the shareholder has a QEF election in effect.

Sec.  1.1061-4 Section 1061 computations.

    (a) Computations.
    (1) Recharacterization Amount.
    (2) One Year Gain Amount and Three Year Gain Amount.
    (i) One Year Gain Amount.
    (ii) Three Year Gain Amount.
    (3) API One Year Distributive Share Amount and API Three Year 
Distributive Share Amount.
    (i) API One Year Distributive Share Amount.
    (ii) API Three Year Distributive Share Amount.
    (4) API One Year Disposition Amount and API Three Year 
Disposition Amount.
    (i) API One Year Disposition Amount.
    (ii) API Three Year Disposition Amount.
    (b) Special rules for calculating the One Year Gain Amount and 
the Three Year Gain Amount.
    (1) One Year Gain Amount equals zero or less.
    (2) Three Year Gain Amount equals zero or less.
    (3) One Year Gain Amount less than Three Year Gain Amount.
    (4) Installment sale gain.
    (5) Special rules for capital gain dividends from regulated 
investment companies (RICs) and real estate investment trusts 
(REITs).
    (i) API One Year Distributive Share Amount.
    (ii) API Three Year Distributive Share Amount.
    (iii) Loss on sale or exchange of stock.
    (6) Pro rata share of qualified electing fund (QEF) net capital 
gain.
    (i) One year QEF net capital gain.
    (ii) Three year QEF net capital gain adjustment.
    (7) Items not taken into account for purposes of section 1061.
    (8) Holding period determination.
    (i) Determination of holding period for purposes of the Three 
Year Gain Amount.
    (ii) Relevant holding period.
    (9) Lookthrough Rule for certain API dispositions.
    (i) Determination that the Lookthrough Rule applies.
    (A) In general.
    (B) Determination that the Lookthrough Rule applies to the 
disposition of a Passthrough Interest.
    (ii) Application of the Lookthrough Rule.
    (10) Section 83.
    (c) Examples.
    (1) Recharacterization rules.
    (2) Special rules examples.
    (d) Applicability date.

Sec.  1.1061-5 Section 1061(d) transfers to related persons.

    (a) In general.
    (b) Transfer.
    (c) Section 1061(d) Recharacterization Amount.
    (d) Special rules.
    (e) Section 1061(d) Related Person.
    (f) Examples.
    (g) Applicability date.

Sec.  1.1061-6 Reporting rules.

    (a) Owner Taxpayer filing requirements.
    (1) In general.
    (2) Failure to obtain information.
    (b) Passthrough Entity filing requirements and reporting.
    (1) Requirement to file information with the IRS and to furnish 
information to API Holder.
    (2) Requirement to request, furnish, and file information in 
tiered structures.
    (i) Requirement to request information.
    (ii) Requirement to furnish and file information.
    (iii) Timing of requesting and furnishing information.
    (A) Requesting information.
    (B) Furnishing information.
    (iv) Manner of requesting information.
    (v) Recordkeeping requirement.
    (vi) Passthrough Entity is not furnished information to meet its 
reporting obligations under paragraph (b)(1) of this section.
    (vii) Filing requirements.
    (viii) Penalties.
    (c) Regulated investment company (RIC) and real estate 
investment trust (REIT) reporting.
    (1) Section 1061 disclosures.
    (i) One Year Amounts Disclosure.
    (ii) Three Year Amounts Disclosure.
    (2) Pro rata disclosures.
    (3) Report to shareholders.
    (d) Qualified electing fund (QEF) reporting.
    (e) Applicability date.


Sec.  1.1061-1  Section 1061 definitions.

    (a) Definitions. The following definitions apply solely for 
purposes of this section and Sec. Sec.  1.1061-2 through 1.1061-6.
    API Gains and Losses are any long-term capital gains and capital 
losses with respect to an API and include:
    (i) The API One Year Distributive Share Amount as defined in Sec.  
1.1061-4(a)(3)(i);
    (ii) The API Three Year Distributive Share Amount as defined in 
Sec.  1.1061-4(a)(3)(ii);
    (iii) The API One Year Disposition Amount as defined in Sec.  
1.1061-4(a)(4)(i);
    (iv) The API Three Year Disposition Amount as defined in Sec.  
1.1061-4(a)(4)(ii); and
    (v) Capital gains or losses from the disposition of Distributed API 
Property.
    API Holder is a person who holds an API.
    Applicable Partnership Interest (API) means any interest in a 
partnership which, directly or indirectly, is transferred to (or is 
held by) an Owner Taxpayer or Passthrough Taxpayer in connection with 
the performance of substantial services by the Owner Taxpayer or by a 
Passthrough Taxpayer,

[[Page 5482]]

or by any Related Person, including services performed as an employee, 
in any ATB unless an exception in Sec.  1.1061-3 applies. For purposes 
of defining an API under this section and section 1061 of the Internal 
Revenue Code (Code), an interest in a partnership also includes any 
financial instrument or contract, the value of which is determined in 
whole or in part by reference to the partnership (including the amount 
of partnership distributions, the value of partnership assets, or the 
results of partnership operations). An Owner Taxpayer and a Passthrough 
Taxpayer can hold an API directly or indirectly through one or more 
Passthrough Entities.
    Applicable Trade or Business (ATB) means any activity for which the 
ATB Activity Test with respect to Specified Actions is met, and 
includes all Specified Actions taken by Related Persons, including 
combining activities occurring in separate partnership tiers or 
entities as one ATB.
    ATB Activity Test has the meaning provided in Sec.  1.1061-2(b)(1).
    Capital account means a capital account maintained under Sec.  
1.704-1(b)(2)(iv) or similar principles.
    Capital Interest Allocations means, with respect to a partnership, 
allocations of long-term capital gain or loss made under the 
partnership agreement to an API Holder and to Unrelated Non-Service 
Partners based on such partners' capital contributed with respect to 
the partnership to the extent such allocations otherwise meet the 
requirements of Sec.  1.1061-3(c). With respect to other Passthrough 
Entities, the principles of this definition apply.
    Capital Interest Disposition Amount has the meaning provided in 
Sec.  1.1061-3(c)(4).
    Capital Interest Gains and Losses has the meaning provided in Sec.  
1.1061-3(c)(2).
    Distributed API Property means property distributed by a 
Passthrough Entity to an API Holder with respect to an API if the 
holding period, as determined under sections 735 and 1223, in the API 
Holder's hands is three years or less at the time of disposition of the 
property by the API Holder.
    Indirect API means an API that is held through one or more 
Passthrough Entities.
    Investing or Developing Actions means actions involving either--
    (i) Investing in (or disposing of) Specified Assets (or identifying 
Specified Assets for such investing or disposition); or
    (ii) Developing Specified Assets (see Sec.  1.1061-2(b)(1)(ii)).
    Lookthrough Rule means the recharacterization rule described in 
Sec.  1.1061-4(b)(9).
    One Year Gain Amount has the meaning provided in Sec.  1.1061-
4(a)(2)(i).
    Owner Taxpayer means the person subject to Federal income tax on 
net gain with respect to an API or an Indirect API during the taxable 
year, including an owner of a Passthrough Taxpayer unless the owner of 
the Passthrough Taxpayer is a Passthrough Entity itself or is excepted 
under Sec.  1.1061-3(a), (b), or (d).
    Passthrough Entity means a partnership, trust, estate, S 
corporation described in Sec.  1.1061-3(b)(2)(i), or passive foreign 
investment company described in Sec.  1.1061-3(b)(2)(ii).
    Passthrough Interest means an interest in a Passthrough Entity that 
represents in whole or in part an API.
    Passthrough Taxpayer means a Passthrough Entity that is treated as 
a taxpayer for the purpose of determining the existence of an API.
    Raising or Returning Capital Actions means actions involving 
raising or returning capital but does not include Investing or 
Developing Actions.
    Recharacterization Amount has the meaning provided in Sec.  1.1061-
4(a)(1).
    Related Person means a person or entity who is treated as related 
to another person or entity under sections 707(b) or 267(b).
    Relevant ATB means the ATB in which services were provided and in 
connection with which an API is held or was transferred.
    Section 1061(d) Recharacterization Amount has the meaning provided 
in Sec.  1.1061-5(c).
    Section 1061(d) Related Person has the meaning provided in Sec.  
1.1061-5(e).
    Section 1061 Regulations means the provisions of this section and 
Sec. Sec.  1.1061-2 through 1.1061-6.
    Specified Actions means the combination of Raising or Returning 
Capital Actions and Investing or Developing Actions.
    Specified Assets means--
    (i) Securities, including interests in partnerships qualifying as 
securities (as defined in section 475(c)(2) without regard to the last 
sentence thereof);
    (ii) Commodities (as defined in section 475(e)(2));
    (iii) Real estate held for rental or investment;
    (iv) Cash or cash equivalents; and
    (v) An interest in a partnership to the extent that the partnership 
holds Specified Assets. See Sec.  1.1061-2(b)(1)(iii).
    (vi) Specified Assets include options or derivative contracts with 
respect to any of the items provided in paragraphs (i) through (v) of 
this definition.
    Three Year Gain Amount has the meaning provided in Sec.  1.1061-
4(a)(2)(ii).
    Unrealized API Gains and Losses means, with respect to a 
Passthrough Entity's assets, all unrealized capital gains and losses 
that would be:
    (i) Realized if those assets were disposed of for fair market value 
in a taxable transaction on the relevant date; and
    (ii) Allocated to an API Holder with respect to its API, taking 
into account the principles of section 704(c).
    Unrelated Non-Service Partners means partners who do not (and did 
not) provide services in the Relevant ATB and who are not (and were 
not) Related Persons with respect to any API Holder in the partnership 
or any person who provides or has provided services in the Relevant 
ATB.
    (b) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after January 19, 2021. An Owner Taxpayer or Passthrough Entity may 
choose to apply this section to a taxable year beginning after December 
31, 2017, provided that they consistently apply the Section 1061 
Regulations in their entirety to that year and all subsequent years.


Sec.  1.1061-2   Applicable partnership interests and applicable trades 
or businesses.

    (a) API rules and examples--(1) Rules--(i) An API remains an API. 
Once a partnership interest qualifies as an API, the partnership 
interest remains an API unless and until the requirements of one of the 
exceptions to qualification of a partnership interest as an API, set 
forth in Sec.  1.1061-3, are satisfied.
    (ii) Application of section 1061 to Unrealized API Gains and 
Losses. Unrealized API Gains and Losses are API Gains and Losses 
subject to section 1061 when the gains and losses are realized and 
recognized. Unrealized API Gains and Losses do not lose their character 
as such until they are recognized.
    (iii) API Gains and Losses retain their character. API Gains and 
Losses retain their character as API Gains and Losses as they are 
allocated from one Passthrough Entity to another Passthrough Entity and 
then to the Owner Taxpayer.
    (iv) Substantial services by an Owner Taxpayer, Passthrough 
Taxpayer, or any Related Person. If an interest in a partnership is 
transferred to or held by an Owner Taxpayer, Passthrough Taxpayer, or 
any Related Person in connection with the performance of services, the 
Owner Taxpayer, the

[[Page 5483]]

Passthrough Taxpayer, or the Related Person is presumed to have 
provided substantial services for purposes of section 1061.
    (v) Grantor trusts and entities disregarded as separate from their 
owners. A trust wholly described in subpart E, part I, subchapter J, 
chapter 1 of the Internal Revenue Code (that is, a grantor trust), a 
qualified subchapter S subsidiary described in section 1361(b)(3), and 
an entity with a single owner that is treated as disregarded as an 
entity separate from its owner under any provision of the Internal 
Revenue Code or any part of 26 CFR (including Sec.  301.7701-3 of this 
chapter) are disregarded for purposes of the Section 1061 Regulations.
    (2) Examples. The following examples illustrate the provisions of 
this paragraph (a).
    (i) Example 1: API. (A) A is the general partner of PRS, a 
partnership, and provides services to PRS. A is engaged in an ATB as 
defined in Sec.  1.1061-1(a). PRS transfers a PRS profits interest to A 
in connection with A's performance of substantial services with respect 
to PRS's ATB. A's interest in PRS is an API.
    (B) After 6 years, A retires and is no longer engaged in an ATB and 
does not perform any services with respect to its ATB and with respect 
to PRS. However, A retains the API in PRS. PRS continues to acquire new 
capital assets and to allocate gain to A from the disposition of those 
assets. Under paragraph (a)(1)(i) of this section, A's interest in PRS 
remains an API after A retires.
    (ii) Example 2: Contribution of an API to a partnership. 
Individuals A, B, and C each directly hold APIs in PRS, a partnership. 
A and B form a new partnership, GP, and contribute their APIs in PRS to 
GP. Following the contribution, each of A and B holds an Indirect API 
because each of A and B now indirectly holds an API in PRS through GP, 
a Passthrough Entity. Each of A's and B's interests in GP is a 
Passthrough Interest because each of A's and B's interest in GP 
represents an Indirect API.
    (iii) Example 3: Passthrough Interest, Indirect API, Passthrough 
Taxpayer. Each of A, B, and C provides services to, and is an equal 
partner in, GP. GP is engaged in an ATB as defined in Sec.  1.1061-
1(a), is the general partner of PRS, and provides substantial 
management services to PRS. In connection with GP's performance of 
substantial services in an ATB, PRS issues a profits interest to GP. 
Because GP's PRS interest was received in connection with GP's 
providing services in an ATB, GP is a Passthrough Taxpayer and GP's 
interest in PRS is an API. Because A, B, and C are partners in GP, they 
each hold a Passthrough Interest in GP and an Indirect API in PRS. Each 
of A, B, and C is treated as an Owner Taxpayer because each is a 
partner in GP and because each holds an Indirect API in PRS in 
connection with the performance of its services to GP's ATB.
    (iv) Example 4: S corporation, Passthrough Interest, Indirect API, 
and Passthrough Taxpayer. A owns all of the stock of S Corp, an S 
corporation. S Corp is engaged in an ATB, as defined in Sec.  1.1061-
1(a). S Corp is the general partner of PRS, a partnership, and provides 
substantial management services to PRS. A provides substantial services 
in S Corp's ATB. In connection with S Corp providing substantial 
services to PRS, PRS issues a profits interest to S Corp. S Corp's 
interest in PRS is its only asset. Because S Corp's profits interest in 
PRS was issued to S Corp in connection with substantial services in an 
ATB, S Corp is a Passthrough Taxpayer and its interest in PRS is an 
API. Because A is a shareholder in S Corp, A holds a Passthrough 
Interest in S Corp and an Indirect API in PRS as a result of S Corp's 
API in PRS. A is treated as an Owner Taxpayer because A holds an 
interest in S Corp, a Passthrough Taxpayer, and also indirectly holds 
an API in PRS in connection with A's services in S Corp's ATB.
    (v) Example 5: Indirect API, Related Person, and Passthrough 
Taxpayer. Each of A, B, and C is an equal partner in partnership GP, 
the general partner of PRS. GP's Specified Actions do not satisfy the 
ATB Activity Test under Sec.  1.1061-1(a) and as a result, GP's actions 
do not establish an ATB. Management Company is a Related Person with 
respect to GP within the meaning of sections 267(b) and 707(b), is 
engaged in an ATB, and provides substantial management services to PRS 
that are sufficient to satisfy the ATB Activity Test. Management 
Company's actions are attributed to GP under paragraphs (a)(1)(iv) and 
(b)(1)(i)(C) of this section because Management Company is a Related 
Person to GP. In connection with Management Company's services to PRS, 
PRS issues a profits interest to GP. Because its PRS profits interest 
is issued to GP in connection with services provided by Management 
Company, a Related Person, GP is a Passthrough Taxpayer and its 
interest in PRS is an API. Unless an exception described in Sec.  
1.1061-3 applies, because A, B, and C are partners in GP, they each 
hold a Passthrough Interest in GP and an Indirect API in PRS. A, B, and 
C are treated as Owner Taxpayers because they hold an interest in GP, a 
Passthrough Taxpayer.
    (b) Application of the ATB Activity Test--(1) In general. The ATB 
Activity Test is satisfied if both Raising and Returning Actions and 
Investing or Developing Actions are conducted by an Owner Taxpayer, 
Passthrough Taxpayer, or one or more Related Persons with respect to an 
Owner Taxpayer or Passthrough Taxpayer, and the total level of 
activity, including the combined activities of all Related Persons, 
satisfies the level of activity that would be required to establish a 
trade or business under section 162.
    (i) Rules for applying the ATB Activity Test--(A) Aggregate 
Specified Actions taken into account. The determination of whether the 
ATB Activity Test is satisfied is based on the combined activities 
conducted that qualify as either Raising or Returning Capital Actions 
and Investing or Developing Actions. The fact that either Raising or 
Returning Capital Actions or Investing or Developing Actions are only 
infrequently taken does not preclude the test from being satisfied if 
the combined Specified Actions meet the test.
    (B) Raising or Returning Capital Actions and Investing or 
Developing Actions are not both required to be taken in each taxable 
year. Raising or Returning Capital Actions and Investing or Developing 
Actions are not both required to be taken in each taxable year in order 
to satisfy the ATB Activity Test. For example, the ATB Activity Test 
will be satisfied if Investing or Developing Actions are not taken in 
the current taxable year, but sufficient Raising or Returning Capital 
Actions are taken in anticipation of future Investing or Developing 
Actions. Additionally, the ATB Activity Test will be satisfied if no 
Raising or Returning Capital Actions are taken in the current taxable 
year, but have been taken in a prior taxable year (regardless of 
whether the ATB Activity Test was met in the prior year), and 
sufficient Investing or Developing Actions are undertaken by the 
taxpayer in the current taxable year.
    (C) Combined conduct by multiple related entities taken into 
account--(1) Related Entities. If a Related Person(s) (within the 
meaning of Sec.  1.1061-1(a)) solely or primarily performs Raising or 
Returning Capital Actions and one or more other Related Person(s) 
solely or primarily performs Investing or Developing Actions, the 
combination of the activities performed by these Related Persons will 
be taken into account in determining whether the ATB Activity Test is 
satisfied.

[[Page 5484]]

    (2) Actions taken by an agent or delegate. Specified Actions taken 
by an agent or a delegate in its capacity as an agent or a delegate of 
a principal will be taken into account by the principal in determining 
whether the ATB Activity Test is satisfied with respect to the 
principal. These Specified Actions are also taken into account in 
determining whether the ATB Activity test is satisfied with respect to 
the agent or the delegate.
    (ii) Developing Specified Assets. Developing Specified Assets takes 
place if it is represented to investors, lenders, regulators, or other 
interested parties that the value, price, or yield of a portfolio 
business may be enhanced or increased in connection with choices or 
actions of a service provider. Merely exercising voting rights with 
respect to shares owned or similar activities do not amount to 
developing Specified Assets.
    (iii) Partnerships. Investing or Developing Actions directly 
conducted with respect to Specified Assets held by a partnership are 
counted towards the ATB Activity Test. Additionally, a portion of the 
Investing or Developing Actions conducted with respect to the interests 
in a partnership that holds Specified Assets is counted towards the ATB 
Activity Test. This portion is the value of the partnership's Specified 
Assets over the value of all of the partnership's assets. Actions taken 
to manage a partnership's working capital will not be taken into 
account in determining the portion of Investing or Developing Actions 
conducted with respect to the interests in the partnership.
    (2) Examples. The following examples illustrate the application of 
the ATB Activity Test described in paragraph (b)(1) of this section.
    (i) Example 1: Combined activities of Raising or Returning Capital 
Actions and Investing or Developing Actions. During the taxable year, B 
takes a small number of actions to raise capital for new investments. B 
takes numerous actions to develop Specified Assets. B's actions with 
respect to raising capital and B's actions with respect to developing 
Specified Assets are combined for the purpose of determining whether 
the ATB Activity Test is satisfied. These actions cumulatively rise to 
the level required to establish a trade or business under section 162. 
Thus, B satisfies the ATB Activity Test.
    (ii) Example 2: Combining Specified Actions in multiple entities. 
GP, a partnership, conducts Raising or Returning Capital Actions. 
Management Company, a partnership that is a Related Person to GP, 
conducts Investing or Developing Actions. When GP's and Management 
Company's activities are combined, the ATB Activity Test is satisfied. 
Accordingly, both GP and Management Company are engaged in an ATB, and 
services performed by either GP or Management Company are performed in 
an ATB under paragraph (b)(1) of this section.
    (iii) Example 3: Investing or Developing Actions taken after 
Raising or Returning Capital Actions that do not meet the ATB Activity 
Test. In year 1, PRS engaged in Raising or Returning Capital Actions to 
fund PRS's investment in Specified Assets. However, PRS' Specified 
Actions during year 1 did not satisfy the ATB Activity Test because 
they did not satisfy the level of activity required to establish a 
trade or business under section 162. Therefore, PRS was not engaged in 
an ATB in year 1. In year 2, PRS engaged in significant Investing or 
Developing Actions but did not engage in any Raising or Returning 
Capital Actions. In year 2, PRS's Investing or Developing Actions rise 
to the level required to establish a trade or business under section 
162. Because PRS has cumulatively engaged in both Investing or 
Developing Actions and Raising or Returning Capital Actions and because 
the Specified Actions rise to the level of activity required to 
establish a trade or business under section 162, PRS is engaged in an 
ATB in year 2.
    (iv) Example 4: Raising or Returning Capital Actions taken in 
anticipation of Investing or Developing Actions. In year 1, A only 
conducted Raising or Returning Capital Actions. A's Raising or 
Returning Capital Actions were undertaken to raise capital to invest in 
Specified Assets with the goal of increasing their value through 
Investing or Developing Actions and rise to the level of activity 
required to establish a trade or business under section 162. A did not 
take Investing or Developing Actions during the taxable year. A's 
Raising or Returning Capital Actions satisfy the ATB Activity Test 
because they were undertaken in anticipation of also engaging in 
Investing or Developing Actions. Therefore, the ATB Activity Test is 
satisfied, and A is engaged in an ATB in year 1.
    (v) Example 5: Attribution of delegate's actions. GP is the general 
partner of PRS. GP is responsible for providing management services to 
PRS. GP contracts with Management Company to provide management 
services on GP's behalf to PRS. GP and Management Company are not 
Related Persons. The Specified Actions taken by Management Company on 
behalf of GP are attributed to GP for purposes of the ATB Activity Test 
because the Management Company is operating as a delegate of GP. 
Additionally, those Specified Actions are taken into account by 
Management Company for purposes of the ATB Activity Test and whether it 
is engaged in an ATB.
    (vi) Example 6: ATB Activity Test not satisfied. A is the manager 
of a hardware store. Partnership owns the hardware store, including the 
building in which the hardware business is conducted. In connection 
with A's services as the manager of the hardware store, a profits 
interest in Partnership is transferred to A. Partnership's business 
involves buying hardware from wholesale suppliers and selling it to 
customers. The hardware is not a Specified Asset. Although real estate 
is a Specified Asset if it is held for rental or investment purposes, 
Partnership holds the building for the purpose of conducting its 
hardware business and not for rental or investment purposes. Therefore, 
the building is not a Specified Asset as to Partnership. Partnership 
also maintains and manages a certain amount of working capital for its 
business, but actions with respect to working capital are not taken 
into account for the purpose of determining whether the ATB Activity 
Test is met. Partnership is not a Related Person with respect to any 
person who takes Specified Actions. Partnership is not engaged in an 
ATB because the ATB Activity Test is not satisfied. Although 
Partnership raises capital, its Raising or Returning Capital Actions 
alone do not satisfy the ATB Activity Test. Further, Partnership takes 
no Investing or Developing Actions because it holds no Specified Assets 
other than working capital. Partnership is not in an ATB and the 
profits interest transferred to A is not an API.
    (c) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after January 19, 2021. An Owner Taxpayer or Passthrough Entity may 
choose to apply this section to a taxable year beginning after December 
31, 2017, provided that they apply the Section 1061 Regulations in 
their entirety to that year and all subsequent years.


Sec.  1.1061-3  Exceptions to the definition of an API.

    (a) A partnership interest held by an employee of another entity 
not conducting an ATB. An API does not include any interest transferred 
to a person in connection with the performance of substantial services 
by that person as an employee of another entity that is conducting a 
trade or business (other than an ATB) and the

[[Page 5485]]

person provides services only to such other entity.
    (b) Partnership interest held by a corporation--(1) In general. An 
API does not include any interest directly or indirectly held by a 
corporation.
    (2) Treatment of interests held by an S corporation or a qualified 
electing fund. For purposes of this section, a corporation does not 
include an entity for which an election was made to treat the entity as 
a Passthrough Entity. Thus, the following entities are not treated as 
corporations for purposes of section 1061--
    (i) An S corporation for which an election under section 1362(a) is 
in effect; and
    (ii) A passive foreign investment company (PFIC) with respect to 
which the shareholder has a qualified electing fund (QEF) election 
under section 1295 in effect.
    (c) Capital Interest Gains and Losses--(1) In general. Capital 
Interest Gains and Losses are not subject to section 1061 and, 
therefore, are not included in calculating an Owner Taxpayer's 
Recharacterization Amount.
    (2) Capital Interest Gains and Losses defined. For purposes of 
paragraph (c)(1) of this section, Capital Interest Gains and Losses are 
Capital Interest Allocations that meet the requirements of paragraph 
(c)(3) of this section and Capital Interest Disposition Amounts that 
meet the requirements of paragraph (c)(4) of this section.
    (3) General rules for determining Capital Interest Allocations--(i) 
Commensurate with capital contributed. An allocation will be considered 
a Capital Interest Allocation if the allocation to the API Holder with 
respect to its capital interest is determined and calculated in a 
similar manner as the allocations with respect to capital interests 
held by similarly situated Unrelated Non-Service Partners who have made 
significant aggregate capital contributions as described in paragraph 
(c)(3)(iv) of this section. For purposes of this paragraph (c)(3), 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.
    (ii) In a similar manner. For purposes of paragraph (c)(3)(i) of 
this section, a Capital Interest Allocation to an API Holder will be 
treated as made in a similar manner if allocations and distribution 
rights with respect to the capital contributed by an API Holder to 
which the API Holder's Capital Interest Allocation relates are 
reasonably consistent with allocation and distribution rights with 
respect to capital contributed by Unrelated Non-Service Partners where 
the Unrelated Non-Service Partner requirement is met. For purposes of 
this paragraph (c)(3)(ii), allocation and distribution rights for an 
API Holder that are limited to a particular class of partnership 
capital interests or that are determined with respect to capital 
contributions invested in a particular partnership investment will be 
considered as made in a similar manner to allocations and distribution 
rights of Unrelated Non-Service Partners where the Unrelated Non-
Service Partner requirement is met for the applicable interest class or 
partnership investment.
    (A) Relevant factors. For purposes of this paragraph (c)(3)(ii), 
the following factors are not exclusive, but are relevant factors in 
determining whether allocation and distribution rights with respect to 
capital contributed by an API Holder are reasonably consistent with 
allocation and distribution rights of persons meeting the Unrelated 
Non-Service Partner requirement: The amount and timing of capital 
contributed, the rate of return on capital contributed, the terms, 
priority, type and level of risk associated with capital contributed, 
and the rights to cash or property distributions during the 
partnership's operations and on liquidation. Accordingly, an allocation 
to an API Holder will not fail to qualify solely because the allocation 
is subordinated to allocations made to Unrelated Non-Service Partners, 
because an allocation to an API Holder is not reduced by the cost of 
services provided by the API Holder or a Related Person to the 
partnership, where the cost of services provided includes management 
fees or API allocations, or because an API Holder has a right to 
receive tax distributions while Unrelated Non-Service Partners do not, 
where such distributions are treated as advances against future 
distributions.
    (B) Clear identification requirement. For purposes of this 
paragraph (c)(3)(ii), allocations will be considered made in a similar 
manner only if the allocations to the API Holder and the Unrelated Non-
Service Partners are allocations with respect to, and corresponding to, 
such partners' contributed capital that are separate and apart from 
allocations made to the API Holder with respect to its API and where 
both the partnership agreement and the partnership's contemporaneous 
books and records clearly demonstrate that the requirements of 
paragraph (c)(3) of this section have been met.
    (iii) Reinvestment of API Gain. If an API Holder is allocated API 
Gain by a Passthrough Entity, to the extent that an amount equal to the 
API Gain is reinvested in the Passthrough Entity by the API Holder 
(either as the result of an actual distribution and recontribution of 
the API Gain amount or the retention of the API Gain amount by the 
Passthrough Entity), the amount will be treated as a contribution to 
the Passthrough Entity for a capital interest that may produce Capital 
Interest Allocations for the API Holder, provided such allocations meet 
the requirements of this paragraph (c)(3).
    (iv) Unrelated Non-Service Partner requirement. For purposes of 
paragraph (c)(3) of this section, the Unrelated Non-Service Partner 
requirement means that Unrelated Non-Service Partners must have made 
significant aggregate capital contributions in relation to total 
capital contributions of all partners. Unrelated Non-Service Partners 
will be treated as having made significant aggregate capital 
contributions provided such partners possess five percent or more of 
the aggregate capital contributed to the partnership at the time the 
allocations are made. With respect to an API Holder with allocation and 
distribution rights that are attributable to a particular interest 
class or partnership investment, the Unrelated Non-Service requirement 
must be met with respect to that particular interest class or 
partnership investment.
    (v) Proceeds of certain loans not taken into account for Capital 
Interest Allocation purposes--(A) General rule. For purposes of the 
Section 1061 Regulations, an allocation is not a Capital Interest 
Allocation to the extent the allocation is attributable to the 
contribution of an amount of capital to a partnership that, directly or 
indirectly, results from, or is attributable to, any loan or other 
advance made or guaranteed, directly or indirectly, by the partnership, 
a partner in the partnership, or any Related Person with respect to 
such persons, except to the extent a loan or advance is described in 
paragraph (c)(3)(v)(B) of this section. However, the repayments on a 
loan described in the preceding sentence are taken into account as 
capital contributed (and may therefore generate Capital Interest 
Allocations) as those amounts are paid by the partner, provided that 
the loan is not repaid with the proceeds of another loan described in 
the preceding sentence.
    (B) Recourse liability. Paragraph (c)(3)(v)(A) of this section does 
not apply with respect to an allocation attributable to a contribution 
made by an individual service provider that,

[[Page 5486]]

directly or indirectly, results from, or is attributable to, a loan or 
advance from another partner in the partnership (or any Related Person 
with respect to such lending or advancing partner, other than the 
partnership) to such individual service provider if the individual 
service provider is personally liable for the repayment of such loan or 
advance. A contribution made by an individual service provider includes 
a contribution made by an entity that is wholly owned by, and 
disregarded as separate from, the individual service provider as 
described in Sec.  1.1061-2(a)(1)(v), including a contribution 
attributable to a loan or advance made to the disregarded entity by 
another partner in the partnership (or any Related Person with respect 
to such lending or advancing partner, other that the partnership) if 
the individual service provider is personally liable for the repayment 
of any and all borrowed amounts that are not repaid by the disregarded 
entity. For purposes of this paragraph (c)(3)(v)(B), an individual 
service provider is personally liable for the repayment of a loan or 
advance made by a partner (or any Related Person, other than the 
partnership) if--
    (1) The loan or advance is fully recourse to the individual service 
provider;
    (2) The individual service provider has no right to reimbursement 
from any other person; and
    (3) The loan or advance is not guaranteed by any other person.
    (vi) Items that are not included in Capital Interest Allocations. 
Capital Interest Allocations do not include--
    (A) Amounts that are treated as API Gains and Losses and Unrealized 
API Gains and Losses; or
    (B) Items that are not taken into account for purposes of section 
1061 under Sec.  1.1061-4(b)(7).
    (4) Capital Interest Disposition Amounts--(i) In general. The term 
Capital Interest Disposition Amount means the amount of long-term 
capital gain or loss recognized on the sale or disposition of all or a 
portion of a Passthrough Interest that is treated as Capital Interest 
Gain or Loss. In general, long-term capital gain or loss recognized on 
the sale or disposition of a Passthrough Interest is deemed to be API 
Gain or Loss unless it is determined under paragraph (c)(4)(ii) of this 
section to be a Capital Interest Disposition Amount.
    (ii) Determination of the Capital Interest Disposition Amount. If a 
Passthrough Interest that includes a right to allocations of Capital 
Interest Gains and Losses is disposed of, the amount of long-term 
capital gain or loss that is treated as a Capital Interest Disposition 
Amount is determined under the rules provided in this paragraph 
(c)(4)(ii).
    (A) First, determine the amount of long-term capital gain or loss 
that would be allocated to the Passthrough Interest (or the portion of 
the Passthrough Interest sold) if all the assets of the Passthrough 
Entity (including gain or loss with respect to assets described in 
Sec.  1.1061-4(b)(7)) were sold for their fair market value in a fully 
taxable transaction immediately before the disposition of the 
Passthrough Interest (hypothetical asset sale). For purposes of this 
paragraph (c)(4)(ii), the assets of the Passthrough Entity include any 
assets held by a lower-tier Passthrough Entity in which the Passthrough 
Entity has a direct or indirect interest.
    (B) Second, determine the amount from the hypothetical asset sale 
that would be allocated to the Passthrough Interest (or the portion of 
the Passthrough Interest sold) as Capital Interest Allocations under 
paragraph (c)(3) of this section.
    (C) Third, if the transferor recognized long-term capital gain upon 
disposition of the Passthrough Interest and only net short-term capital 
losses, net long-term capital losses, or both, are allocated to the 
Passthrough Interest under paragraph (c)(4)(ii)(B) of this section from 
the hypothetical asset sale, all of the long-term capital gain is API 
Gain. If the transferor recognized long-term capital loss on the 
disposition of the Passthrough Interest and only net short-term capital 
gains, net long-term capital gains, or both, are allocated to the 
Passthrough Interest under paragraph (c)(4)(ii)(B) of this section, 
then all the long-term capital loss is API Loss.
    (D) If paragraph (c)(4)(ii)(C) of this section does not apply and 
long-term capital gain is recognized on the disposition of the 
Passthrough Interest, the amount of long-term capital gain that the 
transferor of the Passthrough Interest recognizes that is treated as a 
Capital Interest Disposition Amount is determined by multiplying long-
term capital gain recognized on the disposition of the Passthrough 
Interest by a fraction, the numerator of which is the amount of long-
term capital gain determined under paragraph (c)(4)(ii)(B) of this 
section, and the denominator of which is the amount of long-term 
capital gain determined under paragraph (c)(4)(ii)(A) of this section, 
with the percentage represented by the fraction limited to 100 percent. 
Alternatively, if paragraph (c)(4)(ii)(C) of this section does not 
apply and long-term capital loss is recognized on the disposition of 
the Passthrough Interest, the amount of long-term capital loss treated 
as a Capital Interest Disposition Amount is determined by multiplying 
the transferor's capital loss by a fraction, the numerator of which is 
the amount of long-term capital loss determined under paragraph 
(c)(4)(ii)(B) of this section, and the denominator of which is the 
amount of long-term capital loss determined under paragraph 
(c)(4)(ii)(A) of this section, with the percentage represented by the 
fraction limited to 100 percent.
    (E) In applying this paragraph (c)(4)(ii), allocations of amounts 
that are not included in determining the amount of long-term capital 
gain or loss recognized on the sale or disposition of the Passthrough 
Interest are not included. See, for example, section 751(a).
    (5) Capital Interest Allocations made by a Passthrough Entity that 
is an API Holder. An allocation made to a Passthrough Entity that holds 
an API in a lower-tier Passthrough Entity will be considered a Capital 
Interest Allocation if it meets the principles set forth in paragraphs 
(c)(3) and (4) of this section (other than paragraph (c)(3)(iv) of this 
section). For purposes of applying the Capital Interest Allocation 
rules in this paragraph (c)(5) to a tiered partnership structure, to 
the extent that a Capital Interest Allocation that is made by a lower-
tier partnership to an upper-tier partnership is properly allocated to 
the upper-tier partnership's partners with respect to their capital 
interests in the upper-tier partnership in a manner that is respected 
under 704(b) (taking into account the principles of section 704(c)), 
such allocation is a Capital Interest Allocation.
    (6) Examples. The rules of this paragraph (c) are illustrated by 
the following examples.
    (i) Example 1: Capital Interest Allocations--(A) Facts. Each of A, 
B, and C contributes $100 to GP and is an equal partner in GP, a 
partnership that is the general partner of PRS, a partnership. The 
contributions are not attributable to loans or advances described in 
paragraph (c)(3)(v)(A) of this section. PRS's other partners are 
Unrelated Non-Service Partners. Each of GP and PRS makes allocations to 
its partners in accordance with its partners' interests in that 
partnership, as described in Sec.  1.704-1(b)(3). GP holds a 20% 
profits interest in PRS that is an API that GP received in exchange for 
providing substantial services to PRS in an ATB. GP's API is an 
Indirect API to each of A, B, and C. GP contributes the $300 of capital 
contributed by A, B and C to PRS. GP's $300 contribution equals 2% of 
the contributed capital made by

[[Page 5487]]

all of PRS's partners ($15,000). PRS's partnership agreement describes 
its partners' economic distribution rights with respect to its 
liquidating proceeds as follows: First, liquidating proceeds are 
proportionately distributed to each of GP and the Unrelated Non-Service 
Partners equal to the amount necessary to return each of those 
partners' unreturned capital; second, liquidating proceeds are 
distributed to GP with respect to its API in PRS; and, finally, any 
residual liquidating proceeds are distributed, proportionately, 98% to 
the Unrelated Non-Service Partners and 2% to GP. During its initial 
taxable year, PRS has $10,000 of net capital gain, causing an increase 
in PRS's distributable proceeds of $10,000. In accordance with the 
partners' economic rights as described in PRS's partnership agreement, 
PRS allocates $2,160 of net capital gain to GP (a $2,000 API allocation 
plus $160 ($8,000 ($10,000-$2,000) x 2%), with respect to GP's 
contributed capital) and $7,840 of net capital gain to the Unrelated 
Non-Service Partners with respect to their contributed capital. GP 
allocates $720 ($2,160/3) of this net capital gain to each of A, B, and 
C in accordance with their interests in GP.
    (B) PRS's Capital Interest Allocation Analysis. Because PRS's 
partnership agreement provides for no differences as to the amount and 
timing of capital contributed, the rate of return on capital 
contributed, the type and level of risk associated with capital 
contributed, or the rights to cash or property distributions during the 
PRS's operations and on liquidation, the allocations and distribution 
rights with respect the capital contributed by GP are reasonably 
consistent with the allocation and distribution rights with respect to 
capital contributed by Unrelated Non-Service Partners. Accordingly, 
GP's allocation of $160 is a Capital Interest Allocation that is 
treated as made in a similar manner as the allocations made to the 
Unrelated Non-Service Partners.
    (C) GP Capital Interest Allocation Analysis. GP is allocated $2,160 
from PRS, consisting of a $2,000 API allocation and a $160 Capital 
Interest Allocation. The $160 Capital Interest Allocation is allocated 
equally to A, B, and C based on their capital contributions to GP. 
Therefore, they qualify as Capital Interest Allocations by GP. See 
paragraph (c)(5) of this section. The $2,000 of gain allocated by PRS's 
to GP with respect to GP's API cannot be treated as a Capital Interest 
Allocation by GP and therefore is subject to section 1061. In summary, 
A, B, and C are each allocated $720 of capital gain from PRS ($2,160/
3). Of this amount, $667 is API Gain ($2,000/3) and $53 is a Capital 
Interest Allocation ($160/3).
    (ii) Example 2: Sale of a Passthrough Interest--(A) Facts. In Year 
1, A, B, and C form GP, a partnership. Each of A, B, and C contributes 
$100 to GP and is an equal partner in GP. The contributions are not 
attributable to loans or advances described in paragraph (c)(3)(v)(A) 
of this section. GP invests the $300 in Asset X in Year 1. GP is also 
the general partner of PRS, a partnership. PRS's other partners are 
Unrelated Non-Service Partners. GP holds a 20% profits interest in PRS 
that is an API that GP received in exchange for providing substantial 
services to PRS in an ATB. GP's API is an Indirect API to each of A, B, 
and C. Each of GP and PRS makes allocations to its partners in 
accordance with its partners' interests in that partnership, as 
described in Sec.  1.704-1(b)(3). In Year 3, A sells A's interest in GP 
to an unrelated third party for $800 and recognizes $700 of capital 
gain on the sale. If PRS had sold its assets in a hypothetical asset 
sale as required by paragraph (c)(4)(ii)(A) of this section and 
liquidated immediately before A sold its interest in GP, GP would have 
been allocated $1,800 of long-term capital gain with respect to GP's 
API in PRS, and GP would have allocated $600 of this $1,800 to A. If GP 
sold Asset X for its fair market value and liquidated immediately 
before A sold its interest in GP, A would have been allocated $100 of 
long-term capital gain.
    (B) Analysis. GP does not have a capital interest in PRS. 
Therefore, its allocations from PRS are allocations with respect to its 
API which are subject to section 1061. The total gain allocable to A as 
a result of the hypothetical liquidations would be $700. Under 
paragraph (c)(4)(ii)(D) of this section, $100 of the $700 of A's 
interest sale gain is A's Capital Interest Disposition Amount, and is 
not subject to section 1061.
    (iii) Example 3: Reinvestment of Realized API Gain. A, B, and C are 
partners in PRS, a partnership. At the beginning of Year 1, A is issued 
an API in PRS in exchange for providing substantial services to PRS in 
an ATB. A has no capital interest in PRS. During Year 1, PRS's assets 
appreciate by $100. At the end of Year 1, under the terms of its 
partnership agreement, if PRS were to sell all of its assets at their 
fair market value and distribute the proceeds in a complete 
liquidation, A would receive $20 with respect to its API. Thus, at the 
end of Year 1, A has $20 of Unrealized API Gain. In Year 2, PRS sells 
Asset X, an asset that PRS owned in Year 1, and allocates $8 of the 
long-term capital gain to A as API Gain. As a result, $8 of A's $20 of 
Unrealized API Gain becomes API Gain that is subject to section 1061. A 
reinvests A's share of the proceeds from the Asset X sale in PRS. As a 
result, under paragraph (c)(3)(iii) of this section, A has an $8 
capital interest in PRS and, provided the requirements of paragraph 
(c)(3) of this section are met, A may receive future Capital Interest 
Allocations with respect to the capital interest.
    (d) Partnership interest acquired by purchase by an unrelated 
person. If a person (acquirer) acquires an interest in a partnership 
(target partnership) by taxable purchase for fair market value that, 
but for the exception set forth in this paragraph (d), would be an API, 
the transferor of the interest will be treated as selling an API but 
the acquirer will not be treated as acquiring an API if--
    (1) Acquirer not a Related Person. Immediately before the purchase, 
the acquirer is not a Related Person with respect to--
    (i) Any person who provides services in the Relevant ATB; or
    (ii) Any service providers who provide services to, or for the 
benefit of, the target partnership or a lower-tier partnership in which 
the target partnership holds an interest, directly or indirectly.
    (2) Section 1061(d) not applicable. Section 1061(d) does not apply 
to the transaction (as provided in Sec.  1.1061-5).
    (3) Acquirer not a service provider. At the time of the purchase, 
the acquirer has not provided, does not provide, and does not 
anticipate providing, services in the future, to, or for the benefit 
of, the target partnership, directly or indirectly, or any lower-tier 
partnership in which the target partnership directly or indirectly 
holds an interest.
    (e) [Reserved]
    (f) Applicability date--(1) General rule. Except as provided in 
paragraphs (f)(2) and (3) of this section, the provisions of this 
section apply to taxable years of Owner Taxpayers and Passthrough 
Entities beginning on or after January 19, 2021. An Owner Taxpayer or 
Passthrough Entity may choose to apply this section to a taxable year 
beginning after December 31, 2017, provided that they apply the Section 
1061 Regulations in their entirety to that year and all subsequent 
years.
    (2) Partnership interest held by an S corporation. Paragraph 
(b)(2)(i) of this section, which provides that the exception under 
section 1061(c)(1) to the definition of an API does not apply to a 
partnership interest held by an S corporation with an election under 
section 1362(a) in effect, applies to

[[Page 5488]]

taxable years beginning after December 31, 2017.
    (3) Partnership interest held by a PFIC with respect to which the 
shareholder has a QEF election in effect. Paragraph (b)(2)(ii) of this 
section, which provides that the exception under section 1061(c)(1) to 
the definition of an API does not apply to a partnership interest held 
by a PFIC with respect to which the shareholder has a QEF election in 
effect under section 1295, applies to taxable years of an Owner 
Taxpayer and Passthrough Entity beginning after August 14, 2020.


Sec.  1.1061-4  Section 1061 computations.

    (a) Computations--(1) Recharacterization Amount. The 
Recharacterization Amount is the amount that an Owner Taxpayer must 
treat as short-term capital gain under section 1061(a). The 
Recharacterization Amount equals--
    (i) The Owner Taxpayer's One Year Gain Amount; less
    (ii) The Owner Taxpayer's Three Year Gain Amount.
    (2) One Year Gain Amount and Three Year Gain Amount--(i) One Year 
Gain Amount. The Owner Taxpayer's One Year Gain Amount is the sum of--
    (A) The Owner Taxpayer's combined net API One Year Distributive 
Share Amount from all APIs held during the taxable year; and
    (B) The Owner Taxpayer's API One Year Disposition Amount.
    (ii) Three Year Gain Amount. The Owner Taxpayer's Three Year Gain 
Amount is the sum of--
    (A) The Owner Taxpayer's combined net API Three Year Distributive 
Share Amount from all APIs held during the taxable year; and
    (B) The Owner Taxpayer's API Three Year Disposition Amount.
    (3) API One Year Distributive Share Amount and API Three Year 
Distributive Share Amount--(i) API One Year Distributive Share Amount. 
The API One Year Distributive Share Amount equals--
    (A) The API Holder's distributive share of net long-term capital 
gain or loss from the partnership for the taxable year (including 
capital gain or loss on the disposition of Distributed API Property by 
an API Holder that is a Passthrough Entity or the disposition of all or 
a part of an API by an API Holder that is a Passthrough Entity), with 
respect to the partnership interest held by the API Holder calculated 
without the application of section 1061; less
    (B) To the extent included in the amount determined under paragraph 
(a)(3)(i)(A) of this section, the aggregate of--
    (1) Amounts that are not taken into account for purposes of section 
1061 under paragraph (b)(7) of this section; and
    (2) Capital Interest Gains and Losses as determined under Sec.  
1.1061-3(c)(2).
    (ii) API Three Year Distributive Share Amount. The API Three Year 
Distributive Share Amount equals the API One Year Distributive Share 
Amount, less--
    (A) Items included in the API One Year Distributive Share Amount 
that would not be treated as a long-term gain or loss if three years is 
substituted for one year in paragraphs (3) and (4) of section 1222; and
    (B) Any adjustments resulting from the application of the 
Lookthrough Rule under paragraph (b)(9)(ii) of this section when an API 
is disposed of by an API Holder that is a Passthrough Entity.
    (4) API One Year Disposition Amount and API Three Year Disposition 
Amount--(i) API One Year Disposition Amount. The API One Year 
Disposition Amount is the combined net amount of--
    (A) Long-term capital gains and losses recognized during the 
taxable year by an Owner Taxpayer, including long-term capital gain 
computed under the installment method that is taken into account for 
the taxable year, on the disposition of all or a portion of an API that 
has been held for more than one year, including a disposition to which 
the Lookthrough Rule applies;
    (B) Long-term capital gain and loss recognized by an Owner Taxpayer 
due to a distribution with respect to an API during the taxable year 
that is treated under section 731(a) as gain or loss from the sale or 
exchange of a partnership interest held for more than one year; and,
    (C) Long-term capital gains and losses recognized by an Owner 
Taxpayer on the disposition of Distributed API Property (taking into 
account deemed exchanges under section 751(b)) during the taxable year 
that has a holding period of more than one year but not more than three 
years to the distributee Owner Taxpayer on the date of disposition, 
excluding items described in paragraph (b)(7) of this section.
    (ii) API Three Year Disposition Amount. The API Three Year 
Disposition Amount is the combined net amount of--
    (A) Long-term capital gains and losses recognized during the 
taxable year by an Owner Taxpayer, including long-term capital gain 
computed under the installment method that is taken into account for 
the taxable year, on the disposition of all or a portion of an API that 
has been held for more than three years and to which the Lookthrough 
Rule does not apply;
    (B) Long-term capital gains and losses recognized by an Owner 
Taxpayer on the disposition during the taxable year of all or a portion 
of an API that has been held for more than three years in a transaction 
to which the Lookthrough Rule in paragraph (b)(9) of this section 
applies, less any adjustments required under the Lookthrough Rule in 
paragraph (b)(9)(ii) of this section; and
    (C) Long-term capital gains and losses recognized on a distribution 
with respect to an API during the taxable year that is treated under 
sections 731(a) as gain or loss from the sale or exchange of a 
partnership interest held for more than three years.
    (b) Special rules for calculating the One Year Gain Amount and the 
Three Year Gain Amount--(1) One Year Gain Amount equals zero or less. 
If an Owner Taxpayer's One Year Gain Amount is zero or results in a 
loss, the Recharacterization Amount for the taxable year is zero and 
section 1061(a) does not apply.
    (2) Three Year Gain Amount equals zero or less. If an Owner 
Taxpayer's Three Year Gain Amount is less than or equal to $0, the 
Three Year Gain Amount is zero for purposes of calculating the 
Recharacterization Amount.
    (3) One Year Gain Amount less than Three Year Gain Amount. If the 
One Year Gain Amount and the Three Year Gain Amount are both greater 
than zero but the One Year Gain Amount is less than the Three Year Gain 
Amount, none of the One Year Gain Amount is included in the 
Recharacterization Amount for the taxable year.
    (4) Installment sale gain. The One Year Gain Amount under paragraph 
(a)(2)(i) of this section and the Three Year Gain Amount, as determined 
under paragraph (a)(2)(ii) of this section include long-term capital 
gains from installment sales. This includes long-term capital gain or 
loss recognized with respect to an API after December 31, 2017, with 
respect to an installment sale that occurred on or before December 31, 
2017. The holding period of the asset upon the date of disposition is 
used for purposes of determining whether capital gain is included in 
the taxpayer's One Year Gain Amount or the Three Year Gain Amount.
    (5) Special rules for capital gain dividends from regulated 
investment companies (RICs) and real estate investment trusts (REITs)--
(i) API One Year Distributive Share Amount. If a RIC or REIT reports or 
designates a dividend as a capital gain dividend and provides the One 
Year Amounts

[[Page 5489]]

Disclosure as defined in Sec.  1.1061-6(c)(1)(i), the amount provided 
in the One Year Amounts Disclosure is included in the calculation of an 
API One Year Distributive Share Amount. If the RIC or REIT does not 
provide the One Year Amounts Disclosure, the full amount of the RIC's 
or REIT's capital gain dividend must be included in the calculation of 
an API One Year Distributive Share Amount.
    (ii) API Three Year Distributive Share Amount. If a RIC or REIT 
reports or designates a dividend as a capital gain dividend and 
provides the Three Year Amounts Disclosure as defined in Sec.  1.1061-
6(c)(1)(ii), the amount provided in the Three Year Amounts Disclosure 
is used for the calculation of an API Three Year Distributive Share 
amount. If the RIC or REIT does not provide the Three Year Amounts 
Disclosure, no amount of the RIC's or REIT's capital gain dividend may 
be used for the calculation of an API Three Year Distributive Share 
Amount.
    (iii) Loss on sale or exchange of stock. If a RIC or REIT provides 
the Three Year Amounts Disclosure as provided in paragraph (b)(5)(ii) 
of this section, any loss on the sale or exchange of shares of a RIC or 
REIT held for six months or less is treated as a capital loss on an 
asset held for more than three years, to the extent of the amount of 
the Three Year Amounts Disclosure from that RIC or REIT.
    (6) Pro rata share of qualified electing fund (QEF) net capital 
gain--(i) One year QEF net capital gain. The calculation of an API One 
Year Distributive Share Amount includes an Owner Taxpayer's inclusion 
under section 1293(a)(1)(B) as limited by section 1293(e)(2) with 
respect to a passive foreign investment company (as defined in section 
1297(a)) for which a QEF election (as described in section 1295(a)) is 
in effect for the taxable year. The amount of the inclusion may be 
reduced by the amount of long-term capital gain that is not taken into 
account for purposes of section 1061 as provided in paragraph (b)(7) of 
this section and may be reduced by the Owner Taxpayer's share of the 
excess, if any, of the Capital Interest Gain over Capital Interest Loss 
with respect to the QEF, provided in each case that the relevant 
information is provided by the QEF. See Sec.  1.1061-6 for reporting 
rules.
    (ii) Three year QEF net capital gain adjustment. For purposes of 
calculating an Owner Taxpayer's API Three Year Distributive Share 
Amount, the entire amount determined under paragraph (b)(6)(i) of this 
section, after any allowed reduction, is included as an item in 
paragraph (a)(3)(ii)(A) of this section unless the QEF provides 
information to determine the amount of the inclusion that would 
constitute net capital gain (as defined in Sec.  1.1293-1(a)(2), as 
limited by section 1293(e)(2)) if the QEF's net capital gain for the 
taxable year were calculated under section 1222(11) applying paragraphs 
(3) and (4) of section 1222 by substituting three years for one year. 
If such information is provided, the amount included as an item in 
paragraph (a)(3)(ii)(A) of this section is the amount determined under 
paragraph (b)(6)(i) of this section that would not be treated as long-
term gain if three years were substituted for one year in paragraphs 
(3) and (4) of section 1222. See Sec.  1.1061-6 for reporting rules.
    (7) Items not taken into account for purposes of section 1061. The 
following items of long-term capital gain and loss are excluded from 
the calculation of the API One Year Distributive Share Amount in 
paragraph (a)(3)(i) of this section and the API Three Year Distributive 
Share Amount in paragraph (a)(3)(ii) of this section--
    (i) Long-term capital gain and long-term capital loss determined 
under section 1231;
    (ii) Long-term capital gain and long-term capital loss determined 
under section 1256;
    (iii) Qualified dividends included in net capital gain for purposes 
of section 1(h)(11)(B); and
    (iv) Capital gains and losses that are characterized as long-term 
or short-term without regard to the holding period rules in section 
1222, such as certain capital gains and losses characterized under the 
mixed straddle rules described in section 1092(b) and Sec. Sec.  
1.1092(b)-3T, 1.1092(b)-4T, and 1.1092(b)-6.
    (8) Holding period determination--(i) Determination of holding 
period for purposes of the Three Year Gain Amount. For purposes of 
computing the Three Year Gain Amount, the relevant holding period of 
either an asset or an API is determined under all provisions of the 
Code or regulations that are relevant to determining whether the asset 
or the API has been held for the long-term capital gain holding period 
by applying those provisions as if the holding period were three years 
instead of one year.
    (ii) Relevant holding period. The relevant holding period is the 
direct owner's holding period in the asset sold. Accordingly, for 
purposes of determining an API Holder's Taxpayer's API One Year 
Distributive Share Amount and API Three Year Distributive Share Amount 
for the taxable year under paragraph (a)(3) of this section, the 
partnership's holding period in the asset being sold or disposed of 
(whether a directly held asset or a partnership interest) is the 
relevant holding period for purposes of section 1061.
    (9) Lookthrough Rule for certain API dispositions--(i) 
Determination that the Lookthrough Rule applies--(A) In general. The 
Lookthrough Rule will apply if, at the time of disposition of an API 
held for more than three years--
    (1) The API would have a holding period of three years or less if 
the holding period of such API were determined by not including any 
period before the date that an Unrelated Non-Service Partner is legally 
obligated to contribute substantial money or property directly or 
indirectly to the Passthrough Entity to which the API relates. This 
paragraph (b)(9)(i)(A) does not apply to the disposition of an API to 
the extent that the gain recognized upon the disposition of the API is 
attributable to any asset not held for portfolio investment on behalf 
of third party investors (as defined in section 1061(c)(5)). Solely for 
the purpose of this paragraph (b)(9)(i)(A), a substantial legal 
obligation to contribute money or property is an obligation to 
contribute a value that is at least 5 percent of the partnership's 
total capital contributions as of the time of the API disposition; or
    (2) A transaction or series of transactions has taken place with a 
principal purpose of avoiding potential gain recharacterization under 
section 1061(a).
    (B) Determination that the Lookthrough Rule applies to the 
disposition of a Passthrough Interest. Paragraph (b)(9)(i)(A) of this 
section similarly applies with respect to a Passthrough Interest issued 
by an S corporation or a PFIC to the extent the Passthrough Interest is 
treated as an API.
    (ii) Application of the Lookthrough Rule. If the Lookthrough Rule 
applies, for purposes of applying an Owner Taxpayer's 
Recharacterization Amount, as described in paragraph (a) of this 
section--
    (A) The Owner Taxpayer must include the entire amount of capital 
gain recognized on the disposition of an API by the Owner Taxpayer in 
the Owner Taxpayer's API One Year Disposition Amount; and
    (B) The Owner Taxpayer must include in its Three Year Disposition 
Amount an amount equal its One Year Disposition Amount (determined 
under paragraph (b)(9)(ii)(A) of this section) reduced by the Owner 
Taxpayer's share of the amount of any gain, directly or indirectly, 
from assets held for three years or less that would have been

[[Page 5490]]

allocated to the Owner Taxpayer (to the extent attributable to the 
transferred API) by the partnership if the partnership had sold all of 
its property in a fully taxable transaction for cash in an amount equal 
to the fair market value of such property (taking into account section 
7701(g)) immediately prior to the Owner Taxpayer's transfer of the API.
    (C) In the case of an API disposition by an API Holder that is a 
Passthrough Entity and not an Owner Taxpayer, the principles set forth 
in paragraph (b)(9)(ii)(A) of this section must be applied to determine 
the amount to include in the Owner Taxpayer's One Year Distributive 
Amount and in paragraph (b)(9)(ii)(B) of this section to determine the 
amounts included in the Owner Taxpayer's Three Year Distributive Share 
Amount.
    (10) Section 83. Except with respect to any portion of the interest 
that is a capital interest under Sec.  1.1061-3(c), this section 
applies regardless of whether an Owner Taxpayer or Passthrough Entity 
has made an election under section 83(b) or included amounts in gross 
income under section 83.
    (c) Examples--(1) Recharacterization rules. The rules of paragraph 
(a) of this section are illustrated by the following examples. Unless 
otherwise stated, all gains and losses are long-term capital gains and 
losses, none of the long-term capital gain or loss in this section is 
capital gain or loss not taken into account for purposes of section 
1061 under paragraph (b)(7) of this section, and neither the 
Lookthrough Rule nor section 751 is applicable.
    (i) Example 1: Determination of API One Year and Three Year 
Distributive Share Amounts--(A) Facts. A holds an API in PRS but has no 
capital interest in PRS and is not entitled to a Capital Interest 
Allocation with respect to PRS. During the taxable year, PRS allocates 
to A $20 of long-term capital gain from the sale of capital asset X 
(which had been held by PRS for two years) and $40 of long-term capital 
gain from the sale of capital asset Y (which had held by PRS for five 
years). A has no other items of long-term capital gain or loss with 
respect to its interest in PRS during the taxable year. A has no other 
long-term capital gains or losses with respect to any other API during 
the taxable year.
    (B) Determination of A's API One Year Distributive Share Amount. 
Under paragraph (a)(3)(i) of this section, A has an API One Year 
Distributive Share Amount of $60. This amount is the sum of the $20 of 
the long-term capital gain allocated to A from PRS's sale of capital 
asset X and the $40 of long-term capital gain allocated to A from PRS's 
sale of capital asset Y.
    (C) Determination of A's API Three Year Distributive Share Amount. 
(1) Under paragraph (a)(3)(ii) of this section, A's API Three Year 
Distributive Share Amount is equal to A's API One Year Distributive 
Amount, $60, less the sum of:
    (i) The items included in the API One Year Distributive Share 
Amount that would not be treated as a long-term gain or loss if three 
years is substituted for one year in paragraphs (3) and (4) of section 
1222, $20; and
    (ii) Adjustments resulting from the application of the Lookthrough 
Rule under paragraph (b)(9)(ii) of this section, which under the facts 
in paragraph (c)(1)(i)(A) of this section, is inapplicable.
    (2) Thus, A's Three Year API Distributive Share Amount is $40.
    (D) Determination of A's Recharacterization Amount. Under paragraph 
(a)(2)(i) of this section, A's One Year Gain amount is equal to A's API 
One Year Distributive Share Amount, $60. A's Three Year Gain Amount is 
equal to A's API Three Year Distributive Share Amount, $40. Under 
paragraph (a)(1) of this section, A's Recharacterization Amount is A's 
One Year Gain Amount, minus A's Three Year Gain Amount, or $20.
    (ii) Example 2: API One Year and Three Year Disposition Amounts--
(A) Facts. During the taxable year, A disposes of an API that A has 
held for four years for a $100 gain. Additionally, A sells Distributed 
API Property for a $300 gain at a time when A has a two-year holding 
period in such property. A has no other items of long-term capital gain 
or loss with respect to any API in the year.
    (B) Determination of A's API One Year and Three Year Disposition 
Amounts. Under paragraph (a)(4)(i) of this section, A's API One Year 
Disposition Amount is $400. This amount is the sum of A's $300 of long-
term capital gain on A's disposition of the Distributed API Property 
and A's $100 of long-term capital gain on the disposition of the API. 
Under paragraph (a)(4)(ii) of this section, A's Three Year Disposition 
Amount is $100, which is the amount of long-term capital gain that A 
recognized upon disposition of the API held for more than three years. 
Under paragraph (a)(2) of this section, A's One Year Gain Amount is 
$400 and A's Three Year Gain Amount is $100.
    (C) Determination of A's Recharacterization Amount. Under paragraph 
(a)(1) of this section, A's Recharacterization Amount is $300, which is 
the difference between A's One Year Gain Amount and Three Year Gain 
Amount.
    (iii) Example 3: Determination of One Year Gain Amount, Three Year 
Gain Amount, and Recharacterization Amount--(A) Facts. A holds an API 
in each of PRS1 and PRS2. With respect to PRS1, A's API One Year 
Distributive Share Amount is $100 and A's API Three Year Distributive 
Share Amount is ($200). With respect to PRS2, A's API One Year 
Distributive Share Amount is $600 and A's API Three Year Distributive 
Share Amount is $300. During the taxable year, A also has an API One 
Year Disposition Amount of $200 of gain. A has no other items of long-
term capital gain or loss with respect to an API for the taxable year.
    (B) Determination of A's One Year Gain Amount. Under paragraph 
(a)(2) of this section, A's One Year Gain Amount is $900, which is an 
amount equal to A's $100 API One Year Distributive Share Gain from PRS1 
and A's $600 API One Year Distributive Share from PRS2 (a combined net 
API One Year Distributive Share Amount of $700) plus A's $200 API One 
Year Disposition Amount.
    (C) Determination of A's Three Year Gain Amount. Under paragraph 
(a)(2) of this section, A's Three Year Gain Amount is $100, which is 
equal to A's combined net API Three Year Distributive Share Amount for 
the taxable year (A's $200 API Three Year Distributive Share Amount 
loss from PRS1 plus A's API Three Year Distributive Share Amount Gain 
of $300 from PRS2). A does not have an API Three Year Disposition 
Amount.
    (D) Determination of A's Recharacterization Amount. Under paragraph 
(a)(1) of this section, A's Recharacterization Amount is $800. (A's One 
Year Gain Amount of $900 less A's Three Year Gain Amount of $100.)
    (2) Special rules examples. The principles of paragraph (b) of this 
section are illustrated by the following examples.
    (i) Example 1: Lookthrough Rule. On July 1, 2021, A and B form 
partnership PRS. At the time of PRS's formation, A agrees to provide 
substantial services to PRS in exchange for a 20% profits interest in 
PRS, and B, a partner that is an Unrelated Non-Service Partner, 
contributes $1 million in exchange for an interest in PRS and PRS 
immediately uses the capital to purchase marketable securities. On July 
1, 2023, C, another Unrelated Non-Service Partner becomes legally 
obligated to contribute capital to PRS ($75 million) for the purposes 
of investing in and developing Specified Assets and is admitted into 
PRS. On July 3, 2023, and after C makes a contribution of $75 million, 
PRS uses

[[Page 5491]]

this capital to acquire stock in portfolio company Z. On July 1, 2025, 
when Z has a value of $500 million and the value of the marketable 
securities is $2 million, A sells its API in PRS for $85.2 million. As 
a result of this sale, the Lookthrough Rule applies because B's 
contribution was non-substantial under paragraph (b)(9)(i)(A)(1) of 
this section. Therefore, A includes $85.2 million in its API One Year 
Disposition Amount and under paragraph (b)(9)(ii)(B) of this section, 
$200,000 (20% share of $1 million gain in marketable securities) in its 
API Three Year Disposition Amount. Accordingly, under paragraph (a)(1) 
of this section, A's Recharacterization Amount is $85 million.
    (ii) Example 2: Installment sale gain. On December 22, 2021, A 
disposed of A's API in an installment sale. At the time of the 
disposition, A had held its API for two years. A received a payment 
with respect to the installment sale during A's 2022 taxable year 
causing A to recognize $200 of long-term capital gain. The $200 long-
term capital gain recognized in 2022 is subject to section 1061 because 
it is recognized after December 31, 2017. Accordingly, the $200 of 
long-term capital gain recognized by A in 2022 is included in A's API 
One Year Disposition Amount. The $200 of long-term capital gain is not 
in A's API Three Year Disposition Amount because the API was not held 
for more than three years at the time of its disposition.
    (iii) Example 3: REIT capital gain dividend. During the taxable 
year, A holds an API in PRS. PRS holds an interest in REIT. During the 
taxable year, REIT distributes a $1,000 capital gain dividend to PRS of 
which 50% is allocable to A's API. Part of the capital gain dividend 
for the year results from section 1231 gain. In accordance with Sec.  
1.1061-6(c)(1)(i), REIT discloses to PRS the One Year Amounts 
Disclosure of $400, which is the $1000 capital gain dividend reduced by 
the $600 of section 1231 capital gain dividend included in that amount. 
Part of the One Year Amounts Disclosure for the year results from gain 
from property held for three years or less. In accordance with Sec.  
1.1061-6(c)(1)(ii), REIT also discloses the Three Year Amounts 
Disclosure of $150, which is the $400 One Year Amounts Disclosure 
reduced by the $250 of gain attributable to property held for three 
years or less. PRS includes a $200 gain in determining A's API One Year 
Distributive Share Amount and a $75 gain in determining A's API Three 
Year Distributive Share Amount. See paragraphs (b)(5)(i) and (ii) of 
this section.
    (d) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after January 19, 2021. An Owner Taxpayer or Passthrough Entity may 
choose to apply this section to a taxable year beginning after December 
31, 2017, provided that they apply the Section 1061 Regulations in 
their entirety to that year and all subsequent years.


Sec.  1.1061-5  Section 1061(d) transfers to related persons.

    (a) In general. If an Owner Taxpayer transfers any API or 
Distributed API Property, directly or indirectly, to a Section 1061(d) 
Related Person (as defined in paragraph (e) of this section), the Owner 
Taxpayer must include in gross income as short-term capital gain, an 
amount equal to--
    (1) The short-term capital gain recognized upon the API transfer 
without regard to this paragraph (a); and
    (2) The lesser of--
    (i) The amount of net long-term capital gain recognized by the 
Owner Taxpayer upon the transfer of such interest; or
    (ii) The amount treated as short-term capital gain under paragraph 
(c) of this section (Section 1061(d) Recharacterization Amount).
    (b) Transfer. For purposes of this section, the term transfer means 
a sale or exchange in which gain is recognized by the Owner Taxpayer 
under chapter 1 of the Internal Revenue Code.
    (c) Section 1061(d) Recharacterization Amount. To the extent an 
Owner Taxpayer recognizes long-term capital gain upon a transfer of an 
API to a Section 1061(d) Related Person, the Owner Taxpayer's Section 
1061(d) Recharacterization Amount is the amount of net long-term 
capital gain (excluding amounts not taken into account for purposes of 
section 1061 under Sec.  1.1061-4(b)(7)) from assets held for three 
years or less that would have been allocated to the Owner Taxpayer (to 
the extent attributable to the transferred API) by the partnership if 
the partnership had sold all of its property in a fully taxable 
transaction for cash in an amount equal to the fair market value of 
such property (taking into account section 7701(g)) immediately prior 
to the Owner Taxpayer's transfer of the API. If only a portion of an 
Owner Taxpayer's API is transferred, this paragraph (c) shall apply 
with respect to the portion of gain attributable to the transferred 
interest.
    (d) Special rules. For purposes of this section, the following 
rules are applicable.
    (1) An Owner Taxpayer will be treated as transferring the Owner 
Taxpayer's share of any Indirect API or Distributed API Property if the 
Indirect API or Distributed API Property is transferred by the API 
Holder to a person that is a Section 1061(d) Related Person with 
respect to the Owner Taxpayer.
    (2) The rules set forth in paragraphs (a), (b), and (c) of this 
section apply upon the transfer of a Passthrough Interest issued by an 
S corporation or PFIC to the extent the Passthrough Interest is treated 
as an API.
    (e) Section 1061(d) Related Person. For purposes of this section, 
the term Section 1061(d) Related Person means--
    (1) A person that is a member of the taxpayer's family within the 
meaning of section 318(a)(1);
    (2) A person that performed a service within the current calendar 
year or the preceding three calendar years in a Relevant ATB to the API 
transferred by taxpayer; or
    (3) A Passthrough Entity to the extent that a person described in 
paragraph (e)(1) or (2) of this section owns an interest, directly or 
indirectly.
    (f) Examples. The following examples illustrate the rules of this 
section.
    (1) Example 1: Transfer to child by gift. A, an individual, 
performs services in an ATB and has held an API in connection with 
those services for 10 years. The API has a fair market value of $1,000 
and a tax basis of $0, and no debt is associated with the API. A 
transfers all of the API to A's daughter as a gift. A's daughter is a 
section 1061(d) Related Person but A's gift is not a transfer as 
described in paragraph (b) of this section thus section 1061(d) does 
not apply to A's gift. However, the API remains an API in the hands of 
A's daughter under Sec.  1.1061-2(a)(1)(i).
    (2) Example 2: Transfer of an API to a partnership owned by Section 
1061(d) Related Persons--(i) Facts. A, B, and C are equal partners in 
GP, a partnership. GP holds only one asset, an API in PRS1 which is an 
Indirect API as to each A, B, and C. A, B, and C each provides services 
in the ATB in connection with which GP was transferred its API in PRS1. 
A and B contribute their interests in GP to PRS2 in a Section 721(a) 
exchange for interests in PRS2.
    (ii) Application of section 1061(d). Because the contribution by A 
and B of their interest in GP to PRS2 is an exchange in which no gain 
is recognized by either A or B, the contribution is not a transfer as 
described in paragraph (b) of this section thus section 1061(d) does 
not apply to A and B's contribution. However, the API remains an API in 
the hands of PRS2 under Sec.  1.1061-2(a)(1)(i).

[[Page 5492]]

    (3) Example 3: Transfer of an API to a Section 1061(d) Related 
Person. A holds an API in GP, a partnership which A has owned for four 
years. A transfers the API to a Section 1061(d) Related Person 
described in paragraph (e) of this section in exchange for $100 of 
cash, resulting in A recognizing long-term capital gain of $100. 
Because this is a transfer described in paragraph (b) of this section, 
section 1061(d) applies to the transfer of A's API and A must determine 
its Section 1061(d) Recharacterization Amount under paragraph (c) of 
this section. If, immediately prior to A's transfer of the API, the 
partnership had sold all of its assets in a fully taxable transaction 
for cash equal of the fair market value of the assets, A's share of the 
net long-term capital gain (excluding amounts not taken into account 
for purposes of section 1061 under Sec.  1.1061-4(b)(7)) from assets 
held for three years or less would have been $120. Thus, A's Section 
1061(d) Recharacterization Amount is $120. As a result, A's $100 long-
term capital gain is recharacterized as short-term capital gain under 
paragraph (a) of this section. The API remains an API in the hands of 
the Section 1061(d) Related Person under Sec.  1.1061-2(a)(1)(i).
    (g) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after January 19, 2021. An Owner Taxpayer or Passthrough Entity may 
choose to apply this section to a taxable year beginning after December 
31, 2017, provided that they apply the Section 1061 Regulations in 
their entirety to that year and all subsequent years.


Sec.  1.1061-6  Reporting rules.

    (a) Owner Taxpayer filing requirements-(1) In general. An Owner 
Taxpayer must file such information with the IRS as the Commissioner of 
Internal Revenue or the Commissioner's delegate (Commissioner) may 
require in forms, instructions, or other guidance as is necessary for 
the Commissioner to determine that the Owner Taxpayer has properly 
complied with section 1061 and the Section 1061 Regulations. If an 
Owner Taxpayer requires information from a Passthrough Entity to 
determine the Capital Interest Disposition Amount or the Section 
1061(d) Recharacterization Amount, the Owner Taxpayer must request such 
information from that entity.
    (2) Failure to obtain information. Paragraph (b)(1) of this section 
requires certain Passthrough Entities to furnish an Owner Taxpayer with 
certain amounts necessary to determine its Recharacterization Amount 
and meet its reporting requirements under paragraph (a)(1) of this 
section. To the extent that an Owner Taxpayer is not furnished the 
information required to be furnished under paragraph (b)(1) of this 
section in such time and in such manner as required by the Commissioner 
and the Owner Taxpayer is not otherwise able to substantiate all or a 
part of these amounts to the satisfaction of the Commissioner, then if 
the information with respect to the determination of the--
    (i) API One Year Distributive Share Amount under Sec.  1.1061-
4(a)(3)(i) is not furnished, the API One Year Distributive Share Amount 
will not be reduced by--
    (A) Amounts not taken into account for purposes of section 1061 
under Sec.  1.1061-4(b)(7); or
    (B) Capital Interest Gains and Losses as determined under Sec.  
1.1061-3(c)(2).
    (ii) API Three Year Distributive Share Amount determined under 
Sec.  1.1061-4(a)(3)(ii) is not furnished, all items included in the 
API One Year Distributive Share Amount are treated as items that would 
not be treated as long-term capital gain or loss, if three years is 
substituted for one year in paragraphs (3) and (4) of section 1222.
    (b) Passthrough Entity filing requirements and reporting--(1) 
Requirement to file information with the IRS and to furnish information 
to API Holder. A Passthrough Entity must file such information with the 
IRS as the Commissioner may require in forms, instructions, or other 
guidance as is necessary for the Commissioner to determine that it and 
its partners have complied with section 1061 and the Section 1061 
Regulations. A Passthrough Entity that has issued an API must furnish 
to the API Holder, including an Owner Taxpayer, such information at 
such time and in such manner as the Commissioner may require in forms, 
instructions, or other guidance as is necessary to determine the One 
Year Gain Amount and the Three Year Gain Amount with respect to an 
Owner Taxpayer that directly or indirectly holds the API. A Passthrough 
Entity that has furnished information to the API Holder must file such 
information with the IRS, at such time and in such manner as the 
Commissioner may require in forms, instructions, or other guidance. 
This information includes:
    (i) The API One Year Distributive Share Amount and the API Three 
Year Distributive Share Amount (as determined under Sec.  1.1061-4);
    (ii) Capital gains and losses allocated to the API Holder that are 
excluded from section 1061 under Sec.  1.1061-4(b)(7);
    (iii) Capital Interest Gains and Losses allocated to the API Holder 
(as determined under Sec.  1.1061-3(c)); and
    (iv) In the case of a disposition by an API Holder of an interest 
in the Passthrough Entity during the taxable year, upon the request of 
an API Holder, any information required by the API Holder to properly 
take the disposition into account under section 1061, including--
    (A) Information necessary to apply the Lookthrough Rule and to 
determine the API Holder's Capital Interest Disposition Amount; and
    (B) Information necessary to determine an Owner Taxpayer's Section 
1061(d) Recharacterization Amount.
    (2) Requirement to request, furnish, and file information in tiered 
structures--(i) Requirement to request information. If a Passthrough 
Entity requires information to meet its reporting and filing 
requirements under this section (in addition to any information 
required to be furnished to the Passthrough Entity under paragraph 
(b)(1) of this section) from a lower-tier entity in which it holds an 
interest, the Passthrough Entity must request such information from 
that entity.
    (ii) Requirement to furnish and file information. If information is 
requested of a Passthrough Entity under paragraph (b)(2)(i) of this 
section, the Passthrough Entity must furnish the requested information 
to the person making the request but only to the extent the information 
is necessary for the requesting Passthrough Entity to meet its 
reporting and filing requirements under this section or is required by 
the Commissioner in forms, instructions, or other guidance. If the 
person requesting the information is an API Holder in the Passthrough 
Entity, the information is furnished under paragraph (b)(1) of this 
section. If the Passthrough Entity requesting the information is not an 
API Holder, the Passthrough Entity must furnish the information to the 
requesting Passthrough Entity as required by the Commissioner in forms, 
instructions, or other guidance.
    (iii) Timing of requesting and furnishing information--(A) 
Requesting information. A Passthrough Entity described in paragraph 
(b)(2)(i) of this section must request information under paragraph 
(b)(2)(i) of this section by the later of the 30th day after the close 
of the taxable year to which the information request relates or 14 days 
after the date of a request for information from an upper-tier 
Passthrough Entity.

[[Page 5493]]

    (B) Furnishing information--(1) In general. Except as provided in 
paragraph (b)(2)(iii)(B)(2) of this section, requested information must 
be furnished by the date on which the entity is required to furnish 
information under section 6031(b) or under section 6037(b), as 
applicable.
    (2) Late requests. Information with respect to a taxable year that 
is requested by an upper-tier Passthrough Entity after the date that is 
14 days prior to the due date for a lower-tier Passthrough Entity to 
furnish and file information under section 6031(b) or section 6037(b), 
as applicable, must be furnished and filed in the time and manner 
prescribed by forms, instructions and other guidance.
    (iv) Manner of requesting information. Information may be requested 
electronically or in any manner that is agreed to by the parties.
    (v) Recordkeeping requirement. Any Passthrough Entity receiving a 
request for information must retain a copy of the request and the date 
received in its books and records.
    (vi) Passthrough Entity is not furnished information to meet its 
reporting obligations under paragraph (b)(1) of this section. If an 
upper-tier Passthrough Entity holds an interest in a lower-tier 
Passthrough Entity and it is not furnished the information described in 
paragraph (b)(1) of this section, or, alternatively, if it has not been 
furnished information after having properly requested the information 
under this paragraph (b)(2), the upper-tier Passthrough Entity must 
take actions to otherwise determine and substantiate the missing 
information. To the extent that the upper-tier Passthrough Entity is 
not able to otherwise substantiate and determine the missing 
information to the satisfaction of the Commissioner, the upper-tier 
Passthrough Entity must treat these amounts as provided under paragraph 
(a)(2) of this section. The upper-tier Passthrough Entity must provide 
notice to the API Holder and the IRS regarding the application of this 
paragraph (b)(2) to the information being reported as required in 
forms, instructions, and other guidance.
    (vii) Filing requirements. Both the Passthrough Entity requesting 
the information and the Passthrough Entity furnishing the information 
must file all information with the IRS as the Commissioner may require 
in forms, instructions, or other guidance.
    (viii) Penalties. In addition to the requirement in section 1061(e) 
that the Secretary shall require reporting (at the time and in the 
manner prescribed by the Secretary) as is necessary to carry out the 
purposes of this section, the information required to be furnished 
under this paragraph (b) is also required to be furnished under 
sections 6031(b) and 6037(b). Failure to report as required under this 
paragraph (b) will be subject to penalties under section 6722.
    (c) Regulated investment company (RIC) and real estate investment 
trust (REIT) reporting--(1) Section 1061 disclosures. A RIC or REIT 
that reports or designates a dividend, or part thereof, as a capital 
gain dividend, may, in addition to the information otherwise required 
to be furnished to a shareholder, disclose two amounts for purposes of 
section 1061--
    (i) One Year Amounts Disclosure. The One Year Amounts Disclosure of 
a RIC or REIT is a disclosure by the RIC or REIT of an amount that is 
attributable to a computation of the RIC's or REIT's net capital gain 
excluding capital gain and capital loss not taken into account for 
purposes of section 1061 under Sec.  1.1061-4(b)(7). The aggregate 
amounts provided in the One Year Amounts Disclosures with respect to a 
taxable year of a RIC or REIT must equal the lesser of the RIC's or 
REIT's net capital gain, excluding any capital gains and capital losses 
not taken into account for purposes of section 1061 under Sec.  1.1061-
4(b)(7), for the taxable year or the RIC's or REIT's aggregate capital 
gain dividends for the taxable year.
    (ii) Three Year Amounts Disclosure. The Three Year Amounts 
Disclosure of a RIC or REIT is a disclosure by the RIC or REIT of an 
amount that is attributable to a computation of the RIC's or REIT's One 
Year Amounts Disclosure substituting ``three years'' for ``one year'' 
in applying section 1222. The aggregate amounts provided in the Three 
Year Amounts Disclosures with respect to a taxable year of a RIC or 
REIT must equal the lesser of the aggregate amounts provided in the 
RIC's or REIT's One Year Amounts Disclosures substituting ``three 
years'' for ``one year'' in applying section 1222 for the taxable year 
or the RIC's or REIT's aggregate capital gain dividends for the taxable 
year.
    (2) Pro rata disclosures. The One Year Amounts Disclosure and Three 
Year Amounts Disclosure made to each shareholder of a RIC or REIT must 
be proportionate to the share of capital gain dividends reported or 
designated to that shareholder for the taxable year.
    (3) Report to shareholders. A RIC or REIT that provides the section 
1061 disclosures described in paragraphs (c)(1)(i) and (ii) of this 
section must provide those section 1061 disclosures in writing to its 
shareholders with the statement described in section 852(b)(3)(C)(i) or 
the notice described in section 857(b)(3)(B) in which the capital gain 
dividend is reported or designated.
    (d) Qualified electing fund (QEF) reporting. A passive foreign 
investment company with respect to which the shareholder has a QEF 
election (as described in section 1295(a)) in effect for the taxable 
year that determines net capital gain as provided in Sec.  1.1293-
1(a)(2)(i)(A), as limited by section 1293(e)(2), may provide some or 
all of the information listed in paragraph (b)(1) of this section (and 
any other relevant information) to its shareholders to enable API 
Holders to determine the amount of their inclusion under section 
1293(a)(1) that would be included in the API One Year Distributive 
Share Amounts and API Three Year Distributive Share Amounts. To the 
extent that such information is not provided, paragraph (a)(2) of this 
section will apply except that Owner Taxpayers are not permitted to 
separately substantiate the information. An API Holder who receives the 
additional information described in this paragraph (d) must retain such 
information as required by Sec.  1.1295-1(f)(2)(ii).
    (e) Applicability date. The provisions of this section apply to 
taxable years of Owner Taxpayers and Passthrough Entities beginning on 
or after January 19, 2021. An Owner Taxpayer or Passthrough Entity may 
choose to apply this section to a taxable year beginning after December 
31, 2017, provided that they apply the Section 1061 Regulations in 
their entirety to that year and all subsequent years.

0
Par. 5. Section 1.1223-3 is amended by:
0
1. Redesignating paragraph (b)(5) as paragraph (b)(6);
0
2. Adding a new paragraph (b)(5);
0
3. Designating Examples 1 through 8 of paragraph (f) as paragraphs 
(f)(1) through (8);
0
4. Adding paragraphs (f)(9) and (10); and
0
5. Revising the heading and adding a sentence at the end of paragraph 
(g).
    The additions and revision read as follows:


Sec.  1.1223-3  Rules relating to the holding periods of partnership 
interests.

* * * * *
    (b) * * *
    (5) Divided holding period if partnership interest comprises in 
whole or in part one or more profits interests--(i) In general. If a 
partnership interest is comprised in whole or in part of one or more 
profits interests (as defined in paragraph (b)(5)(ii) of this section), 
then, for purposes of applying paragraph

[[Page 5494]]

(b)(1) of this section, the portion of the holding period to which a 
profits interest relates is determined based on the fair market value 
of the profits interest upon the disposition of all, or part, of the 
interest (and not at the time that the profits interest is acquired). 
Paragraph (b)(1) of this section continues to apply to the extent that 
a partner acquires portions of a partnership interest that are not 
comprised of a profits interest and the value of the profits interest 
is not included for purposes of determining the value of the entire 
partnership interest under paragraph (b)(1).
    (ii) Definition of capital interest and profits interest. For 
purposes of this paragraph (b)(5), a profits interest is a partnership 
interest other than a capital interest. 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 then the proceeds were distributed in a 
complete liquidation of the partnership. A profits interest, for 
purposes of this paragraph (b)(5), is received in connection with the 
performance of services to or for the benefit of a partnership in a 
partner capacity or in anticipation of being a partner, and the receipt 
of the interest is not treated as a taxable event for the partner or 
the partnership under applicable Federal income tax guidance.
* * * * *
    (f) * * *
    (9) Example 9. On June 1, 2020, GP contributes $10,000 to PRS for a 
partnership interest in PRS. On June 30, 2023, GP receives a 20% 
interest in the profits of PRS that is an Applicable Partnership 
Interest (API) as defined in Sec.  1.1061-1(a). On June 30, 2025, GP 
sells its interest in PRS for $30,000. At the time of GP's sale of its 
interest, the API has a fair market value of $15,000. GP has a divided 
holding period in its interest in PRS; 50% of the partnership interest 
has a holding period beginning on June 1, 2020, and 50% has a holding 
period that begins on June 30, 2023.
    (10) Example 10. Assume the same facts as in paragraph (f)(9) of 
this section (Example 9), except that on June 30, 2024, GP contributes 
an additional $5,000 cash to GP prior to GP's sale of its interest in 
2025. Immediately after the contribution of the $5,000 on June 30, 
2024, GP's interest in PRS has a value of $15,000, not taking into 
account the value of GP's profits interest in PRS. GP calculates its 
holding period in the portions not comprised by the profits interest 
and two-thirds of its holding period runs from June 30, 2020, and one-
third runs from June 30, 2024. On June 30, 2025, GP sells its interest 
for $30,000 and the API has a fair market value of $15,000. 
Accordingly, on the date of disposition, one-third of GP's interest has 
a five year holding period from its interest received in 2020 for its 
$10,000 contribution, one-half of GP's interest has a two year holding 
period from the profits interest issued on June 30, 2023, and one-sixth 
of GP's interest has a one year holding period from the contribution of 
the $5,000.
    (g) Applicability dates. * * * Paragraphs (b)(5) and (f)(9) and 
(10) of this section apply to taxable years beginning on or after 
January 19, 2021.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
    Approved: January 5, 2021.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2021-00427 Filed 1-13-21; 4:15 pm]
BILLING CODE 4830-01-P