# Guidance Under Section 1061

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-17108

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** August 14, 2020
- **Citation:** 85 FR 49754

## Text

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-107213-18]
RIN 1545-BO81
Guidance Under Section 1061

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

This document contains proposed 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 proposed 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 in which the applicable partnership interest is held, directly or indirectly.

DATES:

Written or electronic comments and requests for a public hearing must be received by October 5, 2020, which is 60 days after the date of filing for public inspection with the Office of the Federal Register. Requests for a public hearing must be submitted as prescribed in the “Comments and Requests for a Public Hearing” section.

ADDRESSES:

Commenters are strongly encouraged to submit public comments electronically. Submit electronic submissions via the Federal eRulemaking Portal at
www.regulations.gov
(indicate IRS and REG-107213-18) by following the online instructions for submitting comments. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The IRS expects to have limited personnel available to process public comments that are submitted on paper through mail. Until further notice, any comments submitted on paper will be considered to the extent practicable. The Department of the Treasury (Treasury Department) and the IRS will publish for public availability any comment submitted electronically, and to the extent practicable on paper, to its public docket. Send paper submissions to: CC:PA:LPD:PR (REG-107213-18), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.

FOR FURTHER INFORMATION CONTACT:

Concerning submissions of comments and/or requests for a public hearing, Regina L. Johnson at (202) 317-5177 (not a toll-free number); Email address:
fdms.database@irscounsel.treas.gov;
concerning the proposed regulations, Kara K. Altman or Sonia K. Kothari at (202) 317-6850 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background and Overview

This document contains proposed 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 the enactment of 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. This Background and Overview section provides an overview of the statutory provisions and highlights certain critical concepts and terms used in the proposed regulations. The Explanation of Provisions section describes the proposed regulations in greater detail.

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

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. These proposed regulations refer to this difference as the
Recharacterization Amount.

The proposed 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
). The proposed regulations provide a framework for determining the Recharacterization Amount when an API is held through one or more tiers of Passthrough Entities (tiered structure).

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 proposed 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 proposed regulations refer to long-term capital gains and losses recognized with respect to an API as
API Gains and Losses. Unrealized API Gains and Losses
are capital gains and losses with respect to an API that have not yet been realized. In a tiered structure of Passthrough Entities, 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.

The proposed regulations provide that 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). Additionally, API Gains and Losses do not include
API Holder Transition Amounts
and
Capital Interest Gains and Losses.
API Holder Transition Amounts are allocations to the holder of an API (
API Holder
) of long-term capital gain and loss recognized on the disposition of assets held by the partnership for more than three years as of January 1, 2018, if the partnership has elected to treat these amounts as API Holder Transition Amounts. Capital Interest Gains and Losses are long-term capital gains and losses with respect to an API Holder's capital investment in a Passthrough Entity.

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 applicable trade or business (
ATB
).

An API is an interest in a partnership's profits that is transferred or held in connection with the performance of services. There may be one or more tiers of 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 proposed regulations, that is, each Passthrough Entity is an API Holder. An API Holder may be an individual, partnership, trust, estate, S corporation, or a passive foreign investment company (PFIC) with respect to which the shareholder has a qualified electing fund (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). However, section 1061(c)(1) requires that an API be transferred to a taxpayer in connection with services performed by the taxpayer or by a related person. The proposed regulations provide that the reference to “taxpayer” in section 1061(c)(1) includes not only an Owner Taxpayer, but also includes a
Passthrough Taxpayer.
The proposed regulations provide that 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 the Passthrough Entity 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 the Passthrough Entity 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 is transferred in connection with the performance of substantial services. The proposed regulations presume that services are substantial with respect to the partnership interest transferred in connection with those services. This presumption is based on the assumption that the parties have economically equated the services performed with the potential value of the partnership interest transferred. The proposed regulations provide that once a partnership interest is an API, it remains an API and never loses that character, unless one of the exceptions to the definition of an API applies.

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 services in an ATB. An ATB is defined in section 1061(c)(2) as any activity conducted on a regular, continuous, and substantial basis which consists, 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 proposed regulations refer to these actions, respectively, as
Raising or Returning Capital Actions
and
Investing or Developing Actions
(referred to as
Specified Actions
in the aggregate). The proposed 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 proposed regulations provide that, in some cases, it is not necessary for both Raising or Returning Capital Actions and Investing or Developing Actions to occur in a single year for an ATB to exist in that year. Further, Raising or Returning Capital Actions and Investing or Developing Actions of related persons are aggregated 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 proposed 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.

Section 1061(c)(4): Exceptions

Section 1061(c)(4)(A) provides that an API does not include any interest in a partnership directly or indirectly held by a corporation. In Notice 2018-18 (2018-12 IRB 443, March 19, 2018), the Treasury Department and the IRS provided notice that the regulations under section 1061 would provide that the term “corporation” for purposes of section 1061(c)(4)(A) does not include an S corporation. Any timely comments received on Notice 2018-18 will be considered as part of the Treasury decision adopting these proposed regulations as final regulations.

Section 1061(c)(4)(B) also provides that an API does not include certain capital interests. The proposed regulations implement the capital interest exception by excepting long-term capital gains and losses that represent a return on an API Holder's invested capital in a Passthrough Entity from recharacterization under section 1061. The proposed regulations refer to these amounts as
Capital Interest Gains and Losses.
Specifically, under the proposed regulations,
Capital Interest Allocations, Passthrough Interest Capital Allocations
and
Capital Interest Disposition Amounts
are treated as Capital Interest Gains and Losses.

Under the proposed regulations, a partner's invested capital in a partnership that maintains capital accounts under § 1.704-1(b)(2)(iv) is the 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 § 1.704-1(b)(2)(iv)), if the Passthrough Entity maintains and determines accounts for its owners in a manner similar to that provided in § 1.704-1(b)(2)(iv), those accounts will be treated as capital accounts for purposes of the proposed regulations. In order for an allocation to be treated as a Capital Interest Allocation or a Passthrough Interest Capital Allocation, the allocation must be based on an API Holder's relative capital account balance in the Passthrough Entity. Although Unrealized API Gain or Loss is included in an owner's capital account, the gain or loss will be treated as API Gain or Loss and not as Capital Interest Gain or Loss when recognized. An allocation of API Gain or Loss from a lower-tier entity to an upper-tier entity is always API Gain or Loss when further allocated by the upper-tier entity to its direct interest

holders. Capital Interest Gains and Losses never include API Gains and Losses, Unrealized API Gains and Losses, or API Holder Transition Amounts.

If an owner disposes of an interest that is composed of a capital interest and an API, the proposed regulations provide 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.

Other Exceptions

Section 1061(c)(1) provides an exception for certain partnership interests held by employees of entities that are not engaged in an ATB. The proposed regulations track the statutory language. Also, the proposed regulations add an exception for an API that is acquired by a bona fide purchaser who (i) does not provide services, (ii) is unrelated to any service provider, and (iii) acquired the interest for fair market value.

Section 1061(b) provides regulatory authority to establish an exception to section 1061(a) for gain attributable to any assets not held for portfolio investment on behalf of third party investors. The proposed regulations reserve on the exercise of this authority.

Section 1061(d): Transfer of API to a Related Party

Section 1061(d) accelerates the recognition of capital gain on a direct or indirect transfer that would not otherwise be a taxable event and recharacterizes certain long-term capital gain as short-term capital gain. Under section 1061(d), if a taxpayer transfers an API to a related person described in section 1061(d)(2), then, without regard to whether the transfer is otherwise a taxable event, the taxpayer includes in gross income, as short-term capital gain, the excess of (A) the net built-in long-term capital gain in assets attributable to the transferred interest with a holding period of three years or less, over (B) the amount of long-term capital gain treated as short term capital gain under section 1061(a) on the transfer. The proposed regulations provide that the term transfer includes, but is not limited to, contributions, distributions, sales and exchanges, and gifts. A related person for purposes of section 1061(d)(2) 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 proposed regulations, a Passthrough Entity to the extent that a member of the taxpayer's family or a colleague is an owner. The proposed regulations provide that a contribution under section 721(a) to a partnership is not treated as a transfer to a Section 1061(d) Related Person because the proposed regulations require that, under the principles of section 704(c) and §§ 1.704-1(b)(2)(iv)(f) and 1.704-3(a)(9), all Unrealized API Gains at the time of contribution must be allocated to the API Holder contributing the interest when those gains are recognized by the partnership.

Section 1061(e): Reporting

Section 1061(e) provides that the Secretary of the Treasury or his delegate (Secretary) shall require such reporting as is necessary to carry out the purposes of section 1061. The proposed regulations include rules for providing information required to compute the Recharacterization Amount when there is a tiered structure.

Regulatory Authority

The statute requires that the Secretary 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.

Explanation of Provisions

Section 1.1061-1 provides definitions of the terms used in §§ 1.1061-1 through 1.1061-6 of these proposed regulations. Section 1.1061-2 provides rules and examples regarding APIs and ATBs. Section 1.1061-3 provides guidance on the exceptions to an API, including the capital interest exception. Section 1.1061-4 provides guidance on the computation of the Recharacterization Amount and 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, these proposed regulations also provide clarifying amendments to § 1.1223-3. Additional clarifying amendments to § 1.702-1(a)(2) and § 1.704-3(e) are also proposed.

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

Section 1.1061-1 provides definitions of terms used in §§ 1.1061-1 through 1.1061-6 of these proposed regulations. The definitions in § 1.1061-1 combined with the operational rules in § 1.1061-2 identify the taxpayer to which section 1061 applies, when an interest is an API, what constitutes an ATB, and who is a related party. These definitions include terms for identifying interests when an API is held through one or more passthrough entities. For purposes of these regulations, a
Passthrough Entity
is defined as a partnership, an S corporation, or a PFIC with respect to which the shareholder has a QEF election in effect.

A. API, Owner Taxpayer, Passthrough Taxpayer, Indirect API, and Passthrough Interest

1. Definitions

Section 1061(a) refers to a taxpayer in terms of the person whose net long-term capital gains from one or more APIs are recharacterized as net short-term capital gain under the statute. The proposed regulations refer to this amount as the
Recharacterization Amount.
Section 1061(c) also refers to a taxpayer as the person to whom the API is transferred or who holds the API in connection with the taxpayer's or a related person's services.

Section 1061(c)(1) defines an API as any interest in a partnership which, directly or indirectly, is transferred to (or held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or by any other related person, in any ATB. These proposed regulations also provide that solely for purposes of section 1061, an interest in a partnership 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. API, Owner Taxpayer, and Passthrough Taxpayer

Comments and other commentary (collectively referred to as comments) considered by the Treasury Department and the IRS highlight the importance of the definition of the term “taxpayer” for purposes of section 1061(a) with respect

to the determination of the Recharacterization Amount. Additionally, the definition of the term “taxpayer” for purposes of section 1061(c) is important for the determination of whether a partnership interest is an API. These comments describe three potential approaches to the definition of “taxpayer.” These approaches are the aggregate approach, the partial entity approach, and the full entity approach. Under the aggregate approach, both the existence of the API and the Recharacterization Amount are determined solely at the owner level. If the Recharacterization Amount is calculated at the owner level, gains and losses from multiple APIs held by the owner can be combined and netted with each other to determine the Recharacterization Amount. In contrast, under the full entity approach, the Recharacterization Amount and the existence of an API both are determined at the entity level. Additionally, under the full entity approach, the Recharacterization Amount would be calculated for each entity and then netted and combined at the owner level. Under the partial entity approach, the existence of an API is determined at the entity level, but the Recharacterization Amount is determined at the owner level.

The proposed regulations adopt a partial entity approach. To apply this approach, the proposed regulations provide for two definitions of a taxpayer (
Owner Taxpayer
and
Passthrough Taxpayer
) for purposes of section 1061. These definitions are provided to define the scope of the term “taxpayer” for purposes of computing the Recharacterization Amount and for purposes of determining whether a partnership interest is an API. The proposed regulations define the term Owner Taxpayer as the person subject to tax on the net gain with respect to the API. Under the proposed regulations, the Recharacterization Amount is determined solely by the Owner Taxpayer. For this purpose, the term Owner Taxpayer includes individuals, simple and complex trusts, and estates. Thus, if an Owner Taxpayer holds one or more APIs indirectly (through one or more Passthrough Entities), amounts subject to section 1061 flow through those entities and are netted at the Owner Taxpayer level to determine the Recharacterization Amount.

The proposed regulations define the term Passthrough Taxpayer as an entity that generally does not pay tax itself, notwithstanding that a Passthrough Taxpayer could be responsible for paying an imputed underpayment calculated based on adjustments to partnership related items under section 6225 (Partnership adjustment by the Secretary) or that a Passthrough Taxpayer that is an electing 1987 partnership (as defined in section 7704(g)(2)) could be responsible for paying the tax set forth in section 7704(g)(3). An Owner Taxpayer and a Passthrough Taxpayer each are treated as a taxpayer for the purpose of determining whether an API exists. In determining whether the elements of an API are present, a Passthrough Taxpayer can be (i) the service provider, (ii) a person related to the service provider, (iii) engaged in an ATB, or (iv) the recipient of an interest in connection with the performance of substantial services in an ATB. If a Passthrough Taxpayer is treated as the recipient (or holder) of a partnership interest, directly or indirectly, for purposes of determining the existence of an API, the ultimate owners of the Passthrough Taxpayer are treated as Owner Taxpayers for the purpose of determining the Recharacterization Amount. Owner Taxpayers do not include owners of a Passthrough Taxpayer who are excepted from the application of section 1061 under § 1.1061-3. Additionally, Owner Taxpayers to whom a partnership interest is directly or indirectly transferred in connection with the Owner Taxpayer's or a related party's performance of substantial services in an ATB are also treated as taxpayers for purposes of determining the existence of an API. Section 1.1061-2 of the proposed regulations provides examples of how the existence of an API is determined.

b. Interaction With Revenue Procedures 93-27 and 2001-43

Revenue Procedure 93-27 (1993-2 C.B. 343) defines a profits interest and provides a safe harbor under which the IRS will not treat the receipt of a profits interest as a taxable event for the partner or the partnership if certain requirements are met.
See also
Revenue Procedure 2001-43 (2001-2 C.B. 191). Section 1061 applies to all partnership interests that meet the definition of an API, regardless of whether the receipt of the interest is treated as a taxable event under Revenue Procedure 93-27. Accordingly, taxpayers should not equate an interest that meets the definition of an API with an interest the receipt of which would not be treated as a taxable event under Revenue Procedure 93-27. For example, Revenue Procedure 93-27 applies to a person who receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner. Section 1061 applies to partnership interests transferred or held in connection with the performance of substantial services in an ATB. Further, these proposed regulations address only the application of section 1061 and should not be interpreted as providing guidance regarding the application of Revenue Procedure 93-27 to transactions in which one party provides services and another party receives a seemingly associated allocation and distribution of partnership income and gain. Lastly, although a financial instrument or contract may be treated as an API under section 1061, a financial instrument or contract is not an interest in a partnership for purposes of Revenue Procedure 93-27, unless it is otherwise a partnership interest for Federal tax purposes. The Treasury Department and the IRS note that arrangements that are not partnership interests for Federal tax purposes are not eligible for the safe harbor described in Revenue Procedures 93-27 and 2001-43.

c. API Holder

The proposed regulations include the term
API Holder
to refer to any person who holds an interest in a particular API. An API Holder can include either or both a Passthrough Taxpayer and an Owner Taxpayer.

d. Indirect API

The proposed regulations define an
Indirect API
as an API that is held through one or more Passthrough Entities.

e. Passthrough Interest

A
Passthrough Interest
under the proposed regulations is an interest in a Passthrough Entity that represents, in whole or in part, an API.

f. API Gains and Losses and Unrealized API Gains and Losses

API Gains and Losses
are long-term capital gains and losses recognized with respect to an API. The proposed regulations provide that API Gains and Losses include long-term capital gain or loss from a deemed or actual disposition of the API (including gain and loss recognized under section 731(a) and section 752(b)) and the holder's distributive share of net long-term capital gain or loss from the partnership under sections 702 and 704 with respect to the API. The proposed regulations also treat long-term capital gain or loss on the disposition of a capital asset distributed from a partnership with respect to an API (
Distributed API Property
) as API Gain or Loss if the asset

is held for more than one year but not more than three years at the time the distributee-partner disposes of the property. The holding period of the asset in the partner's hands includes the partnership's holding period with respect to the asset.

Unrealized API Gains and Losses
include unrealized short-term and long-term capital gains and losses that would be allocated to the API Holder with respect to its API if the partnership sold all of its assets at fair market value and the proceeds were distributed in a complete liquidation of the partnership on any relevant date. For example, Unrealized API Gains and Losses include all capital gains and losses that would be allocated to the API pursuant to a capital account revaluation under § 1.704-1(b)(2)(iv)(f) or § 1.704-1(b)(2)(iv)(s).

In the case of a Passthrough Entity that contributes property that on disposition would generate capital gain or loss subject to section 1061 to another Passthrough Entity, Unrealized Capital Gains and Losses include the appreciation or depreciation in the value of the property at the time of the contribution. Accordingly, Unrealized API Gains and Losses include the capital gains and losses that would be allocated to the API Holder with respect to the API if the property contributed by the Passthrough Entity to the lower-tier Passthrough Entity were sold immediately before the contribution for the amount that is included in the invested capital of the lower-tier Passthrough Entity (
i.e.,
included in a partnership's capital account or a similar account maintained by another type of Passthrough Entity under § 1.1061-3(c)(3)(ii) of these proposed regulations) with respect to the contributed property.

In the case of a revaluation of the property of a partnership that owns an interest in a tiered structure of partnerships or in the case of the contribution of an API to another Passthrough Entity, the proposed regulations provide that Unrealized API Gains and Losses include capital gains and losses that would be allocated directly or indirectly to the API Holder by lower-tier partnerships determined as if a taxable disposition of the property of each of the lower-tier partnerships also occurred on the date of the revaluation or contribution.

Although the proposed regulations do not require revaluations under section 1.704-1(b)(2)(iv)(f), solely to determine and identify Unrealized API Gains and Losses for purposes of section 1061 upon the occurrence of a revaluation or contribution, these regulations require that a revaluation under the principles of § 1.704-1(b)(2)(iv)(f) be made through each relevant tier of partnerships. Thus, the proposed regulations require revaluations of all the properties held by all relevant partnerships in a tiered structure to determine the extent to which the partnership has Unrealized API Gains and Losses. If a partnership is required to revalue its assets for purposes of section 1061, such partnership is permitted to revalue its property for purposes of section 704 as though an event in § 1.704-1(b)(2)(iv)(f)(5) had occurred.

Further, the proposed regulations require that Unrealized API Gains and Losses of a partnership be allocated when recognized under principles consistent with § 1.704-3(a)(9). Accordingly, if at the time an API Holder contributes an interest in a lower-tier partnership to an upper-tier partnership, and the lower-tier partnership holds property with Unrealized API Gains and Losses that are allocable to the API Holder, those gains and losses when recognized by the lower-tier partnership must be allocated by the upper-tier partnership to the API Holder for purposes of section 1061.

The Treasury Department and the IRS believe that these rules serve two purposes. First, the rules ensure that capital gains and losses that would be API Gains and Losses are not converted to Capital Interest Gains and Losses by virtue of a revaluation or a contribution. Second, these rules also ensure that Unrealized API Gains and Losses of a partnership when recognized are properly allocated to the correct API Holder in a tiered structure of partnerships. The Treasury Department and the IRS request comments on whether such section 1061 revaluations are necessary or whether there is another mechanism that would ensure that API Gain or Loss is allocated to API Holders when there is a revaluation event in one or more of the tiers of entities. Further, comments are requested on whether the section 704(b) regulations should be amended to specifically include revaluations when such partnership revalues its assets for purposes of section 1061 or to address revaluations through tiers of partnerships for purposes of section 704 more generally.

Unrealized API Gains and Losses that are recognized with respect to an asset or API held for more than one year on the date of its disposition become API Gains and Losses at the time they are recognized and do not lose their character as they are allocated through Passthrough Entities in a tiered structure. API Gains and Losses do not include any amounts that otherwise are treated as ordinary income under any Code section including section 751 and section 1245.

The Treasury Department and the IRS are aware that taxpayers may seek to circumvent section 1061(a) by waiving their rights to gains generated from the disposition of a partnership's capital assets held for three years or less and substituting for these amounts gains generated from capital assets held for more than three years. Alternatively, taxpayers may waive their rights to API Gains and substitute gains that are not taken into account for purposes of determining the Recharacterization Amount. Some arrangements also may include the ability for an API Holder to periodically waive its right to an allocation of capital gains from all assets in favor of an allocation of capital gains from assets held for more than three years and/or a priority fill up allocation designed to replicate the economics of an arrangement in which the API Holder shares in all realized gains over the life of the fund. These arrangements are often referred to as carry waivers or carried interest waivers. Taxpayers should be aware that these and similar arrangements may not be respected and may be challenged under section 707(a)(2)(A), §§ 1.701-2 and 1.704-1(b)(2)(iii), and/or the substance over form or economic substance doctrines.

g. Related Persons

Section 1061(c)(1) provides that an API includes an interest transferred to or held by a taxpayer in connection with the performance of substantial services by the taxpayer or a related person in an applicable trade or business. Section 1061(d) also provides a rule for transfers of APIs to certain related persons. Section 1061(d)(2) provides a definition of related person that applies solely to transfers subject to section 1061(d) and the proposed regulations refer to that person as a
Section 1061(d) Related Person.
However, section 1061 does not include a definition of related person for the remainder of section 1061. Accordingly, in defining
Related Person,
the proposed regulations use the general definition of a person or entity that is related under sections 707(b) or 267(b) of the Code.

2. API Operational Rules

a. An API Retains Its Status as an API

Section 1061 does not contain a provision that would cause an interest to cease to be an API unless and until one of the exceptions to the definition of API applies. Therefore, the proposed regulations clarify that once a

partnership interest becomes an API, the partnership interest remains an API unless and until an exception applies, regardless of whether the taxpayer or a Related Person continues to provide services in an ATB. Therefore, even after a partner retires and provides no further services, if the retired partner continues to hold the partnership interest, it remains an API. Similarly, if the partner provides services, but the ATB Activity Test (as defined below) is not met in a later year, the partnership interest will continue to be an API. Further, an API remains an API if it is contributed to another Passthrough Entity or a trust or is held by an estate. As discussed with respect to the definition of API Gains and Losses and further in paragraph I.A.2.b. of this Explanation of Provisions, any unrecognized API Gains and Losses included in a capital account upon contribution of an API to a Passthrough Entity remain subject to section 1061 when they are recognized under the Code.

b. API Gains and Losses and Unrealized API Gains and Losses Retain Their Character

API Gain or Loss retains its character as API Gain or Loss as it is allocated through tiered Passthrough Entities. Similarly, Unrealized API Gain or Loss retains its character even though it is included in the invested capital of a Passthrough Entity (
i.e.,
included in a partnership's capital account or a similar account maintained by another type of Passthrough Entities under § 1.1061-3(c)(3)(ii)).

c. Substantial Services

Section 1061(c)(1) provides that an interest in a partnership is an API only if the interest is transferred to or held by the taxpayer in connection with the performance of substantial services by the taxpayer, or by a related person, in an ATB. If a taxpayer provides any services in an ATB and an allocation of a partnership's profits is transferred to or held by the taxpayer in connection with those services, the proposed regulations presume that those services are substantial for purposes of Section 1061. The Treasury Department and the IRS have concluded that if an interest is granted in connection with the performance of services, such services are presumed substantial with respect to the interest transferred. This presumption is appropriate because the parties to the arrangement have economically equated the potential value of the interest granted with the value of the services performed. Therefore, the services provided are presumed to be substantial with respect to the interest transferred.

The Treasury Department and the IRS request comments on this presumption and the specifics of any arrangements in which insubstantial services could be performed in connection with the receipt of a profits interest such that the presumption could be overcome. Those comments also should address how and why Revenue Procedure 93-27 and Revenue Procedure 2001-43 would apply to partnership interests received in exchange for such insubstantial services.

d. Disregarded Entities

Entities that are disregarded from their owners (collectively, disregarded entities) under any provision of the Code or regulations, including grantor trusts and qualified subchapter S subsidiaries, are disregarded for purposes of these regulations. Accordingly, if an API is held by or transferred to a disregarded entity, the API is treated as held by or transferred to the disregarded entity's owner.

B. ATB and the ATB Activity Test

1. Relevant Definitions

The proposed regulations provide that an ATB means any activity for which the
ATB Activity Test
with respect to
Specified Actions
is met. The proposed regulations provide that the ATB Activity Test is met if Specified Actions are conducted at a level of activity required for an activity to constitute a trade or business under section 162. For purposes of determining if the ATB Activity Test is met, all of the Specified Actions conducted by Related Persons are combined. If these Specified Actions, all taken together, rise to the level of activity required to establish a trade or business under section 162, then each Related Person is determined to be engaged in the
Relevant ATB.
A Relevant ATB is the ATB in which services were performed in connection with which the API was transferred. Multiple Related Persons' actions are combined and then attributed to each Related Person. Therefore, a single ATB under section 1061 can include the actions taken by multiple Related Persons. The definition of an ATB is not the same as the definition of activity under section 469 and does not take into account any of the grouping rules under section 469. The definition of an ATB is solely for purposes of section 1061.

Specified Actions include both
Raising or Returning Capital Actions
and
Investing or Developing Actions.
The proposed regulations' description of Raising or Returning Capital Actions tracks the statutory language of section 1061(c)(2)(A). Similarly, the proposed regulations' description of Investing or Developing Actions tracks the statutory language of section 1061(c)(2)(B). The proposed regulations also include guidance regarding developing Specified Assets from the Conference Report. Specifically, the Conference Report states that developing specified assets takes place, for example, if it is represented to investors, lenders, regulators, or others 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 or of others acting in concert with or at the direction of a service provider. However, merely voting shares owned does not amount to development; for example, a mutual fund that merely votes proxies received with respect to shares of stock it holds is not engaged in development. Conference Report at 421. The proposed regulations provide that Raising or Returning Capital Actions do not include Investing or Developing Actions.

The definition of Specified Assets in the proposed regulations generally tracks the statutory definition of specified assets in section 1061(c)(3). Both the statute and the proposed regulations provide that a Specified Asset generally includes a security as defined in section 475(c)(2). Thus, all corporate stock, regardless of the size of the corporation or whether the corporation is publicly traded, is a specified asset. Additionally, the proposed regulations, consistent with the definition of security in section 475(c)(2), provide that an interest in a partnership or a beneficial ownership interest in a trust is a Specified Asset if it is a security described in section 475(c)(2). The proposed regulations follow the statute to provide that options or derivative contracts with respect to any of the foregoing Specified Assets are also Specified Assets. Further, as provided in section 1061(c)(3), an interest in a partnership is also a Specified Asset to the extent that the partnership itself holds Specified Assets. The Blue Book provides an example in which a hedge fund acquires an interest in a partnership that is neither publicly traded nor widely held and whose assets consist of stocks, bonds, positions that are clearly identified hedges with respect to securities, and commodities. The Blue Book provides that the partnership interest is a specified asset for purposes of the provision. Blue Book at 203. The proposed regulations

incorporate this concept as illustrated by the Blue Book. Similar to the statute's treatment of options or derivative contracts of other Specified Assets as Specified Assets, the proposed regulations provide that, solely for purposes of section 1061, Specified Assets also include a derivative of a partnership interest to the extent not otherwise included in the definition of Specified Assets.

2. The ATB Activity Test

a. Actions Taken With Respect to Specified Assets Held by a Partnership

In the case of a partnership that directly holds Specified Assets, actions taken with respect to or on account of these assets, as well as a percentage of the actions taken with respect to the partnership interest as a whole, will be taken into account for purposes of the ATB Activity Test. The percentage of the actions taken with respect to the partnership as a whole that are taken into account for the test is the ratio of the value of the partnership's Specified Assets over the value of all of the partnership's assets. Actions taken to manage working capital will not be taken into account for purposes of the ATB Activity Test. The Treasury Department and the IRS request comments on the application of this rule and how it can be tailored to accomplish the purposes of section 1061.

b. Application of the ATB Activity Test

i. Aggregate Actions Taken Into Account

The proposed regulations provide that the ATB Activity Test takes into account the aggregate actions conducted with respect to Raising or Returning Capital Actions and Investing or Developing Actions. In other words, the ATB Activity Test does not require that Raising or Returning Capital Actions and Investing or Developing Actions each individually meet the required activity level for the ATB Activity Test to be satisfied.

ii. Raising or Returning Capital Actions and Investing or Developing Actions Are Not Required To Be Taken Every Year

The Treasury Department and the IRS recognize that, in some cases, once sufficient capital to engage in Investing or Developing Actions has been raised, actions involving raising or returning capital may not be taken for a period of time. Additionally, at the beginning and the end of the activity, actions involving the raising or returning of capital may be significant and actions involving investing or developing may not be taken. The ATB Activity Test looks at the actions taken as a whole. Accordingly, the proposed regulations provide that the ATB Activity Test is met if Investing or Developing Actions alone satisfy the ATB Activity Test in the current year if Raising or Returning Capital Actions have been taken in prior years. Additionally, the test is satisfied if Raising or Returning Capital Actions during the year satisfy the ATB Activity Test and Investing or Developing Actions are anticipated but not yet taken.

iii. Actions of Related Persons Taken Into Account

The proposed regulations further provide that in applying the ATB Activity Test, the actions of one or more Related Persons are taken into account, regardless of whether an entity conducts only Raising or Returning Capital Actions or only Investing or Developing Actions.

iv. Interests Transferred Prior to Existence of an ATB

An API arises when an interest in a partnership is transferred or held in connection with services in an ATB. The Treasury Department and the IRS are aware that interests in a partnership may be issued to a service provider in anticipation of the service provider providing services to an ATB, but because an ATB does not exist at the time of the transfer, the interest is not an API. The Treasury Department and the IRS have concluded that once the service provider is providing services in an ATB, the interest becomes an API. Once the interest becomes an API, its status as an API does not depend on whether the ATB continues to meet the ATB Activity Test.

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

Section 1061 includes four exceptions to its application. Additionally, these regulations provide an additional exception. First, the statutory definition of an API excepts 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 (non-ATB employee exception). 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 (corporate exception). Third, section 1061(c)(4)(B) provides that an API does not include any capital interest in the partnership (Capital Interest Gains and Losses exception). 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 (Section 1061(b) exception). Lastly, § 1.1061-3 introduces a fifth exception that applies to an unrelated purchaser who is a non-service provider (bona fide unrelated purchaser exception).

A.
Non-ATB Employee Exception

Section 1061(c)(1) provides that an API is not 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. The proposed regulations track the language of the statute.

B.
Corporate Exception

Section 1061(c)(4)(A) provides that the term API does not include a partnership interest directly or indirectly held by a corporation. On March 19, 2018, the Treasury Department and the IRS issued Notice 2018-18, notifying taxpayers that the Treasury Department and the IRS intended to issue regulations providing that the term corporation as used in section 1061(c)(4)(A) does not include an S corporation. The notice informed taxpayers that the regulations under section 1061 would provide that this rule is effective for taxable years beginning after December 31, 2017 to prevent taxpayers from avoiding the application of section 1061 through the use of an S corporation.
See
section 7805(b)(3). The Blue Book also provides that the term corporation for purposes of section 1061(c)(4)(A) does not include an S corporation. Blue Book, page 201. Accordingly, these proposed regulations provide that partnership interests held by S corporations are treated as APIs if the interest otherwise meets the API definition.

The Treasury Department and the IRS also have concluded that a partnership interest held by a PFIC with respect to which a taxpayer has a QEF election in effect is treated as an API if the interest meets the API definition. Under section 1291, generally, a U.S. person who owns stock of a PFIC is subject to an interest charge regime in which interest is charged with respect to certain PFIC distributions and dispositions of PFIC shares. However, the shareholder can avoid the interest charge regime by making an election under section 1295 to treat the PFIC as a QEF. If this election is made, then the holder of the stock generally is not subject to the interest charge regime and instead includes in income each taxable year its

pro rata share of the ordinary income and long-term capital gain of the QEF. The Treasury Department and the IRS are concerned that, absent this rule, taxpayers may use PFICs with respect to which they have made QEF elections to avoid the application of section 1061. Such taxpayers would have the benefit of passthrough tax treatment without the application of section 1061. The Treasury Department and the IRS believe it is inappropriate for a PFIC with respect to which the shareholder has elected to receive passthrough treatment to be treated as a corporation for purposes of section 1061. Therefore, the proposed regulations clarify that a PFIC with respect to which the shareholder has a QEF election in effect is not treated as corporation for purposes of section 1061(c)(4)(A). As a result, a partnership interest held by a PFIC with respect to which the shareholder has a QEF election in effect will be treated as an API if the interest otherwise meets the API definition.

Section 1061(f) provides that the Secretary has authority to issue regulations as are 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 Treasury Department and the IRS have concluded that the grant of regulatory authority in section 1061 is sufficient for the government 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. The rule that the exception in section 1061(c)(4)(A) does not apply to a PFIC with respect to which the shareholder has a QEF election in effect applies to all taxable years beginning after the date the proposed regulations are published in the
Federal Register
.

C.
Capital Interest Gains and Losses Exception

Section 1061(c)(4)(B) provides that an API does not include a capital interest in the partnership that 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 statutory language creates an exception from recharacterization under section 1061 for capital gains and losses with respect to a capital interest. The Conference Report includes an example in which a partnership agreement provides that a partner's share of the partnership's capital is commensurate with the amount of capital the partner contributed at the time the partnership interest was received compared to the total partnership capital. The reference to the amount of capital contributed in section 1061(c)(4)(B)(i) and a similar reference in the Conference Report indicate that the exception for capital interests should apply only to the extent that a service provider's rights with respect to its contributed capital matches the rights of other non-service partners with respect to their shares of contributed capital. Conference Report at 420-21.

These proposed regulations provide rules for determining if capital gains and losses allocated to an API Holder are treated as allocations with respect to its capital investment and therefore, excluded from the application of section 1061. As discussed in more detail in section II.C.1, of this Explanation of Provisions, General Rules Applicable to the Determination of Capital Interest Allocations and Passthrough Interest Allocations, an allocation must be made in proportion to the relative value of the API Holder's capital account (including unrealized gains and losses) in the Passthrough Entity in order to be an allocation with respect to a capital investment. The proposed regulations also provide rules for determining the amount of gain or loss recognized on the disposition of a Passthrough Interest that is allocable to the capital interest.

The proposed regulations refer to capital gains and losses with respect to a capital interest as Capital Interest Gains and Losses. Specifically, the proposed regulations provide that Capital Interest Gains and Losses are Capital Interest Allocations, Passthrough Interest Capital Allocations and Capital Interest Disposition Amounts.

1. General Rules Applicable to the Determination of Capital Interest Allocations and Passthrough Interest Capital Allocations

a. In the Same Manner

The proposed regulations provide that allocations based on the partners' capital account balances that have the same terms, the same priority, the same type and level of risk, the same rate of return, the same rights to cash or property distributions during partnership operations and on liquidation will be treated as made in the same manner. The proposed regulations also provide that an allocation to an API Holder will not fail to be treated as a Capital Interest Allocation solely because it is subordinated to an allocation to Unrelated Non-service Partners or because it is not reduced by the cost of services provided by the API Holder or by a related person.

b. Capital Accounts

In the case of a partnership that maintains capital accounts under § 1.704-1(b)(2)(iv), in order for an allocation to qualify as a Capital Interest Allocation or a Passthrough Interest Capital Allocation, the allocation must be based on the capital account determined under § 1.704-1(b)(2)(iv). In the case of a Passthrough Entity that is not a partnership (or a partnership that does not maintain capital accounts under § 1.704-1(b)(2)(iv)), if the Passthrough Entity maintains and determines accounts for its owners in a manner similar to that provided under § 1.704-1(b)(2)(iv), those accounts will be treated as capital accounts under the proposed regulations. These accounts must be used in order for an allocation to qualify as a Capital Interest Allocation or a Passthrough Interest Capital Allocation. To qualify to be treated as a capital account for this purpose, each owner's account must be increased by the money and the net fair market value of property contributed to the Passthrough Entity and income and gain allocated to the owner. Each owner's account must be decreased by any money and the net fair market value of property distributed to the owner and allocations of expenditures, loss, and deduction.

Generally, Passthrough Interest Capital Allocations must be based on each owner's share of the Passthrough Entity's capital account in the partnership making the Capital Interest Allocations to the Passthrough Entity. Passthrough Interest Direct Investment Allocations generally must be based on each owner's share of the capital investment made by the Passthrough Entity. This amount is equal to the capital account of the owner reduced by that owner's share of a capital account held directly or indirectly by the Passthrough Entity in a lower-tier entity. However, if a Passthrough Entity allocates all Passthrough Interest Capital Allocations for the taxable year in the aggregate, regardless of whether they are Capital Interest Allocations or Passthrough Interest Direct Investment Allocations, the Passthrough Entity may allocate those allocations based on each owner's capital account in the Passthrough Entity, regardless of whether some or all of an owner's

capital contribution is included in the capital account of a lower-tier entity.

For purposes of section 1061, 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 or the partnership (or any person related to any such other partner or the partnership). However, the repayments on the loan are included in capital accounts as those amounts are paid (unless the repayments are funded with a similar loan from the partners or the partnership or any person related to such partners or the partnership).

c. Items That Are Not Treated as Capital Interest Allocations or Passthrough Interest Capital Allocations

Capital Interest Allocations and Passthrough Interest Capital Allocations never include any amounts that are treated as API Gains and Losses or Unrealized API Gains and Losses that are allocated to the Passthrough Entity by a lower-tier Passthrough Entity. Such allocations also exclude Partnership Transition Amounts and other items not taken into account for purposes of section 1061 as described in section III.E of this Explanation of Provisions.

2. Capital Interest Allocations

Capital Interest Allocations can be made only by a partnership that has both API Holders and Unrelated Non-Service Partners. Unrelated Non-Service Partners are partners who do not (and did not) provide services in the Relevant ATB and who are not (and were not) related to an API Holder in the partnership or any person who provides services in the Relevant ATB. Capital Interest Allocations are allocations of long-term capital gain and loss made under the partnership agreement to the API Holder and Unrelated Non-Service Partners based on their respective capital account balances if: (1) The allocations are made to Unrelated Non-Service Partners with a significant aggregate capital account balance; (2) the allocations are made in the same manner to the API Holder and the Unrelated Non-Service Partners; and (3) the terms of the allocations to the API Holder and the Unrelated Non-Service Partners are identified both in the partnership agreement and on the partnership's books and records and the allocations are clearly separate and apart from allocations made with respect to the API.

These proposed regulations provide that allocations made to Unrelated Non-service Partners with an aggregate capital account balance of 5 percent or more of the aggregate capital account balance at the time the allocation is made by the partnership will be treated as significant.

3. Passthrough Interest Capital Allocations

Passthrough Interest Capital Allocations are long-term capital gain and loss allocations made by a Passthrough Entity that holds an API. The proposed regulations provide for two types of Passthrough Interest Capital Allocations: Passthrough Capital Allocations and Passthrough Interest Direct Investment Allocations.

a. Passthrough Capital Allocations

Passthrough Capital Allocations are Capital Interest Allocations made directly or indirectly to the Passthrough Entity from a lower-tier entity with respect to its capital account balance in the lower-tier entity. Passthrough Capital Allocations must be made by the Passthrough Entity to each of its owners in the same manner based on each owner's share of the capital account in the lower-tier entity making the Capital Interest Allocation to the Passthrough Entity.

b. Passthrough Interest Direct Investment Allocations

Allocations are treated as Passthrough Interest Direct Investment Allocations if the allocations are comprised solely of long-term capital gains and losses derived from assets (other than an API) directly held by the Passthrough Entity and not through an allocation from a lower tier Passthrough Entity. Also, if a Passthrough Entity received Distributed API Property from a lower-tier entity and the property is no longer Distributed API Property because it has been held for more than three years, the property is included in the Passthrough Entity's direct investment at that time. Generally, allocations must be made in the same manner to each of the owners of the Passthrough Entity based on each owner's relative investment in the assets held by the Passthrough Entity. An allocation will not fail to qualify to be a Passthrough Interest Direct Investment Allocation if the Passthrough Entity is a partnership and allocations made to one or more Unrelated Non-Service Partners have more beneficial terms than allocations to the API Holders if the allocations to the API Holders are made in the same manner. For example, if an Unrelated Non-Service Partner receives a priority allocation and distribution of 10 percent of net long-term capital gain and loss and the other partners, including the API Holders, share the remaining 90 percent of the net long-term capital gain from the Passthrough Entity's direct investments, allocations to the API Holders are Passthrough Interest Direct Investment Allocations. Further, allocations made in the same manner to some API Holders by a partnership will not fail to qualify to be treated as a Passthrough Interest Direct Investment Allocation as to those partners despite allocations being made to one or more service providers (or related parties) that are treated as APIs issued by the Passthrough Entity. For example, if (1) all of the partners of the Passthrough Entity are API Holders and one partner manages the Passthrough Entity's direct investments and receives a 20 percent interest in the net long-term capital gains from those investments that is treated as an API as to that partner and (2) the other API Holders share the remaining 80 percent of gain from those investments based on their relative investments in the Passthrough Entity, then (3) the allocation of the 80 percent of net long-term capital gain is a Passthrough Interest Direct Investment Allocation to those partners.

c. Aggregate Passthrough Interest Allocations

Instead of separately accounting for Passthrough Capital Allocations and Passthrough Interest Direct Investment Allocations, owners of the Passthrough Entity may prefer to allocate items of Capital Interest Gain or Loss without regard to whether these items arose from direct investment by the Passthrough Entity or from an investment in a lower-tier Passthrough Entity. Therefore, the proposed regulations permit an upper-tier Passthrough Entity to allocate its Passthrough Capital Allocations and Passthrough Interest Direct Investment Allocations in the same manner to all of its partners using the partners' capital accounts in such Passthrough Entity unreduced by amounts that are included in a capital account of the lower-tier entity.

4. Request for Comments Regarding Other Allocations

The Treasury Department and the IRS understand that the allocations in the proposed regulations do not include all allocation arrangements. The Treasury Department and the IRS request comments on other allocation arrangements that appropriately could be treated as Capital Interest Gains and Losses under the regulations without inappropriately expanding the capital interest exception, taking into account the statutory requirement that the API Holder's right with respect to its capital interest be commensurate with other

partners' rights with respect to their contributed capital.

5. Capital Interest Disposition Amounts

The proposed regulations provide rules for determining the extent to which long-term capital gain or loss recognized on the disposition of a Passthrough Interest comprised of both an API and a capital interest is excluded from section 1061 because it is treated as Capital Interest Gain or Loss. Nothing in section 1061 or these proposed regulations overrides existing law regarding the determination of gain recognized on the disposition of all or a portion of a Passthrough Interest. In particular, in the case of a disposition of a portion of a Passthrough Interest, Revenue Ruling 84-53 (1984-1 C.B. 159) applies and basis must be equitably apportioned between the portion of the interest disposed of and the portion retained. These proposed regulations contain amendments to § 1.1223-3 for determining a divided holding period when a partnership interest includes an API and/or a profits interest.

A commenter requested guidance on whether a capital interest can be disposed of separately from an API for purposes of section 1061(a). The disposition of a capital interest will be treated as such under section 1061 and the gain or loss on the disposition is treated as Capital Interest Gain or Loss if the interest being disposed of is clearly identified as a capital interest. However, nothing in section 1061 or these proposed regulations changes the established partnership principle that a partner has a unitary basis in its partnership interest.
See
Revenue Ruling 84-53. As noted above, the basis must be equitably apportioned to the transferred portion under the principles described in Rev. Rul. 84-53 and the holding period of the interest would be determined under the rules of § 1.1223-3. Thus, a partner may dispose of solely a capital interest or an API, but in either case, the partner's basis and holding period (including a split holding period) is apportioned between the interest retained and the interest transferred.

The proposed regulations provide that the amount of long-term capital gain or loss recognized on a disposition that is treated as a Capital Interest Disposition Amount is determined in a multi-step process. Amounts that are treated as ordinary income under section 751(a) or (b) as a result of the disposition are excluded from all steps of the calculation. The computation then proceeds as follows. First, the amount of gain or loss that would be allocated to the Passthrough Interest (or the portion of the Passthrough Interest sold) if all of the assets of the Passthrough Entity were sold for their fair market value in a fully taxable transaction (deemed liquidation) immediately before the disposition is determined (Step One). Second, the amount of gain or loss from the deemed liquidation that is allocable to the Passthrough Interest as a result of Capital Interest Allocations, and Passthrough Interest Capital Allocations is determined (Step Two). If a transferor recognizes capital gain under section 751(b), any amount that constitutes API Gain or Loss is added to any API Gain or Loss that results from the disposition of the interest.

If gain is recognized under the Code on the disposition of a Passthrough Interest, and the Capital Interest Allocations, Passthrough Interest Capital Allocations, and API Holder Transition Amounts determined under Step Two would result in the allocation of a loss, then all the gain recognized on the disposition will be treated as API Gain. Similarly, if loss is recognized on the disposition of a Passthrough Interest, and the Capital Interest Allocations, Passthrough Interest Capital Allocations, and API Holder Transition Amounts determined under Step Two would result in an allocation of a gain, then all of the loss recognized on the disposition will be treated as an API Loss.

If gain is recognized under the Code on the disposition of a Passthrough Interest and gain would be recognized with respect to the Passthrough Interest under both Step One and Step Two, the API Holder must determine the portion of the gain that is attributable to the capital interest and the portion of the gain that is attributable to the API. To determine these portions, the taxpayer must divide the capital gain that would be allocated to the interest pursuant to Capital Interest Allocations, Passthrough Interest Capital Allocations, and API Holder Transition Amounts on the deemed liquidation of the partnership under Step Two by the total amount of gain that would be allocated to the interest on the deemed liquidation under Step One. This amount, expressed as a percentage, is then multiplied by the total amount of gain recognized on the sale to determine the amount of the gain that is treated as a Capital Interest Disposition Amount. A similar analysis would apply if a loss was recognized on the disposition of the interest, and both Steps One and Two resulted in a loss. To the extent that the gain or loss is not treated as a Capital Interest Disposition Amount, it is API Gain or Loss and subject to section 1061.

6. Recapitalizations and Divisions

The Treasury Department and the IRS are aware that some taxpayers have taken the position that a recapitalization or division is a capital contribution under section 1061(c)(4)(B) that would allow taxpayers to recharacterize what would be API Gains under these proposed regulations as Capital Interest Gains. Although a recapitalization or a division may be treated as a section 721 contribution, these transactions would not have the effect of recharacterizing API Gains and Losses as Capital Interest Gains and Losses under these proposed regulations. The section 1061 statutory language does not support this position and the Treasury Department and the IRS do not believe it to be a reasonable interpretation of the statute.

D. Section 1061(b) Exception

Section 1061(b) provides that to 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). A third party investor is defined in section 1061(c)(5) as a person who holds an interest in the partnership which does not constitute property held in connection with an applicable ATB; and who does not provide substantial services for such partnership or for any applicable trade or business. Comments have suggested that the exception is intended to apply to family offices, that is, portfolio investments made on behalf of the service providers and persons related to the services providers. The Treasury Department and the IRS generally agree with these comments and believe that the section 1061(b) exception effectively is implemented in the proposed regulations with the exception to section 1061 for Passthrough Interest Direct Investment Allocations. The Treasury Department and the IRS request comments on the application of this provision and whether the proposed regulations' exclusion for Passthrough Interest Direct Investment Allocations properly implements the exception.

E. Bona Fide Unrelated Purchaser Exception

The proposed regulations add an exception for unrelated taxpayers who purchase an API. The proposed regulations provide that an interest in a partnership that would be treated as an API but is purchased by an unrelated buyer for the fair market value of the interest is not an API with respect to the

buyer if (1) the buyer does not currently and has never provided services in the relevant ATB (or to the Passthrough Entity in which the interest is held, if different), (2) does not contemplate providing services in the future, and (3) is not related to a person who provides services currently or has provided services in the past. However, it should be noted that this exception does not apply to an unrelated non-service provider 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. 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.

III. Section 1.1061-4: Computing the Recharacterization Amount

As noted in section I of this Explanation of Provisions, under the proposed regulations, the amount an Owner Taxpayer must treat as short-term capital gain under section 1061(a) is called the Recharacterization Amount. The Recharacterization Amount is the amount by which the Owner Taxpayer's
One Year Gain Amount
exceeds the Owner Taxpayer's
Three Year Gain Amount.
The Owner Taxpayer's One Year Gain Amount is comprised of two components: (1) The Owner Taxpayer's combined net
API One Year Distributive Share Amount
from all APIs held during the taxable year; and (2) The Owner Taxpayer's
API One Year Disposition Amount.
The Owner Taxpayer's Three Year Gain Amount is comprised of: (1) Its combined net
API Three Year Distributive Share Amount
from all APIs held during the taxable year; and (2) its
API Three Year Disposition Amount.
As noted earlier in this preamble, API Gains and Losses retain their character as they flow through each tier of Passthrough Entities and are netted at the Owner Taxpayer level to determine the Recharacterization Amount.

A. Determination of the API One Year Distributive Share Amount

Each Passthrough Entity must calculate an API One Year Distributive Share Amount for each API Holder that directly holds an interest in the Passthrough Entity for the taxable year. Under the proposed regulations, all long-term capital gain and loss allocated to the API Holder by the Passthrough Entity are API Gains and Losses to the API Holder unless an exception applies.

If the Passthrough Entity is a partnership, the Passthrough Entity determines its API One Year Distributive Share Amount in a series of steps. First, the partnership determines the long-term capital gains and losses that are allocated to the API Holder under the partnership agreement under sections 702 and 704. This amount includes long-term capital gains and losses from the taxable disposition of Distributed API Property by the partnership that was distributed to it from a lower-tier entity. Second, the partnership reduces this amount by amounts that are not taken into account under these proposed regulations for purposes of calculating the Recharacterization Amount. As discussed in section III.E of this Explanation of Provisions, section 1231 amounts, section 1256 amounts, and qualified dividends are excluded from the calculation of the Recharacterization Amount and are not included in the API One Year Distributive Share amount. The same is true for the API Holder Transition Amount, which is also discussed in section III.E of this Explanation of Provisions, and for long-term capital gain or loss from the disposition of property that was once Distributed API Property but that has ceased to be Distributed API property because it was disposed of when the asset had a holding period that was more than three years. Third, the partnership reduces the amount determined under the second step by any amounts that are treated as Capital Interest Gains and Losses under § 1.1061-3(c). The resulting amount is the API Holder's One Year Distributive Share Amount and the partnership must report this amount to the API Holder as its API One Year Distributive Share Amount under § 1.1061-6. Additionally, under § 1.1061-6, the partnership must report to the API Holder the amount of Capital Interest Gains and Losses and API Holder Transition Amounts that have been allocated to the API Holder for the calendar year.

An API One Year Distributive Share Amount must also be calculated by an S corporation that holds an API for each direct API Holder in the S corporation. In this case, the S corporation must report to each API Holder its pro rata share of the API Gains and Losses allocated to the S corporation with respect to its API. Such amounts also may be calculated and reported by a PFIC with respect to which the shareholder has a QEF election in effect.

B. Determination of the API Three Year Distributive Share Amount

Under the proposed regulations, the API Three Year Distributive Share Amount is equal to an API Holder's One Year Distributive Share Amount less amounts that would not be treated as long-term capital gain and loss if such amount were computed by applying paragraphs (3) and (4) of section 1222 and substituting three years for one year in those paragraphs. In addition, if the Passthrough Entity sold an API during the taxable year and the Lookthrough Rule applies, the API Holder's One Year Distributive Share Amount is further reduced by the adjustment required by the Lookthrough Rule as described in section III.E of this Explanation of Provisions. These amounts must be calculated by the Passthrough Entity and reported to the API Holder under § 1.1061-6.

C. Determination of the API One Year Disposition Amount and the API Three Year Disposition Amount

The API One Year Disposition Amount includes the long-term capital gains and losses that the Owner Taxpayer recognizes from the direct taxable disposition of an API, including gain or loss under sections 731(a) and 752(b), that has been held for more than one year. The API One Year Disposition Amount also includes long-term capital gain or loss recognized on the disposition of Distributed API Property by an Owner Taxpayer. The API Three Year Disposition Amount includes only the long-term capital gain or loss from the direct taxable disposition of an API held by the Owner Taxpayer for more than three years. However, if the Lookthrough Rule, as described in § 1.1061-4(b)(9) and discussed further in section III.E.7 of this Explanation of Provisions, applies, the API Three year Disposition Amount is further reduced by the adjustment required by the Lookthrough Rule.

Section 751(b) provides that in the case of certain disproportionate distributions, a partner may be treated as engaging in a sale or exchange of property with the partnership. To the extent that such an exchange results in long-term capital gain with respect to an API under section 751(b), it is included in the One Year Disposition Amount and additionally, if appropriate, amounts may be included in the Three Year Disposition Amount.
See
§ 1.751-1(b)(2).

D. Determination of the One Year Gain Amount and Three Year Gain Amount

In determining the One Year Gain Amount and Three Year Gain Amount, all amounts are netted at the Owner Taxpayer level. If an Owner Taxpayer holds more than one API, the Owner Taxpayer combines and nets its API Distributive Share Amounts from each API that it held during the taxable year

to determine its combined net API One Year Distributive Share Amount and net API Three Year Distributive Share Amount. Additionally, the taxpayer must take into account its API One Year Disposition Amount and its API Three Year Disposition Amount. If the One Year Gain Amount is zero or less than zero, section 1061 does not apply because there is no gain to recharacterize. Further, in applying section 1(h) of the Code, the Owner Taxpayer determines its net capital gain for the taxable year taking into account section 1061. Comments are requested regarding the calculation of collectibles gain and loss under section 1(h)(5) and unrecaptured section 1250 gain in section 1(h)(6) in cases where collectibles gain or unrecaptured section 1250 gain is included in the Recharacterization Amount under section 1061(a) and under section 1061(d).

E. General Calculation Rules

This section discusses general rules included in the proposed regulations for calculating the One Year Gain Amount and Three Year Gain Amount.

1. Items Not Taken Into Account for Purposes of Section 1061(a)

Section 1061(a) applies to assets that produce capital gains or losses that are treated as long-term capital gain under paragraphs (3) and (4) of section 1222. 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 proposed regulations provide that long-term capital gains determined under section 1231 or section 1256 are excluded from both the One Year and Three Year Gain Amounts. For similar reasons, amounts treated as qualified dividends under section 1(h)(11) and any capital gain that is characterized as long term or short term without regard to the holding period rules in section 1222, such as capital gains characterized under the identified mixed straddle rules described in section 1092(b) and §§ 1.1092(b)-3T, 1.1092(b)-4T, and 1.1092(b)-6, are also excluded.

2. API Holder Transition Amounts

As described in the discussion of Capital Interest Gains and Losses, section 1061(c)(4) provides an exception with respect to certain capital interests. Prior to the enactment of section 1061, taxpayers had no reason to track what portion of the unrealized appreciation in partnership assets was attributable to capital interests. Therefore, the Treasury Department and the IRS are aware that partnerships may not have information readily available to enable them to comply with these regulations with respect to property that the partnership held for more than three years as of the effective date of section 1061. Accordingly, the proposed regulations provide a transition rule for partnership property that was held by the partnership for more than three years as of the effective date of section 1061. Under these proposed regulations, a partnership that was in existence as of January 1, 2018 may irrevocably elect to treat all long-term capital gains and losses from the disposition of all assets, regardless of whether they would be API Gains or Losses in prior periods, that were held by the partnership for more than three years as of January 1, 2018 as
Partnership Transition Amounts.
Partnership Transition Amounts that are allocated to the API Holder (
API Holder Transition Amounts
) are not taken into account for purposes of determining the Recharacterization Amount. Rather, they are treated as long-term capital gains and losses and are not subject to recharacterization under section 1061 and these proposed regulations.

For amounts to be treated as Partnership Transition Amounts, the partnership must make a signed and dated election (election statement) by the due date, including extensions, of the Form 1065, “U.S. Return of Partnership Income,” for the first partnership taxable year in which it treats amounts as Partnership Transition Amounts. The election statement must be identified as an election under § 1.1061-4(b)(7)(iii) and filed with the IRS as an attachment to the Form 1065 filed for the partnership's taxable year in which it is making the election. By the due date of the election, the partnership must clearly and specifically identify all of the assets held by the partnership for more than three years as of January 1, 2018 in the partnership's books and records. The election applies to the year for which the election is made and all subsequent years. Taxpayers may rely on these proposed regulations to make the election for taxable years beginning in 2020 or in a later year before the final regulations apply.

As noted above, Partnership Transition Amounts that are allocated to the API Holder are called API Holder Transition Amounts under the proposed regulations. The API Holder Transition Amount in any year is the amount of the Partnership Transition Amount for the year that is included in the amount of long-term capital gains and losses allocated to the API Holder under sections 702 and 704 with respect to its interest in the partnership under the current partnership agreement. However, the amount allocated to the API Holder in any taxable year under the preceding sentence cannot exceed the amount of the Partnership Transition Amount that would have been allocated to the API Holder with respect to its partnership interest under the partnership agreement for the 2017 taxable year to the extent it was amended on or before March 15, 2018. The partnership must retain an executed copy of the partnership agreement in effect for the 2017 taxable year to the extent amended on or before March 15, 2018 as part of its books and records.

A Passthrough Entity that receives an allocation of API Holder Transition Amounts from a lower-tier entity cannot allocate more of the Passthrough Entity's API Holder Transition Amount to the Passthrough Entity's direct API Holders than the amount of Partnership Transition Amounts the API Holders would have been allocated by the Passthrough Entity under the Passthrough Entity's governing documents in effect for the calendar year ending December 31, 2017 to the extent amended on or before March 15, 2018. Further, the amount allocated to the Passthrough Entity's direct API Holders cannot exceed the amount of the Passthrough Entity's API Holder Transition Amounts the Passthrough Entity was allocated by the lower-tier Passthrough Entity.

Unlike other provisions of the proposed regulations, API Holders and Passthrough Entities may elect and treat amounts as Partnership Transition Amounts and API Holder Transition Amounts for taxable years beginning in 2020 or a later taxable year without following all of the provisions of the proposed regulations provided that the partnership consistently treats long-term capital gains and losses from identified assets as Partnership Transition Amounts and API Holder Transition Amounts for the year in which the election is made and all subsequent taxable years beginning before the final regulations are published in the
Federal Register
. The Treasury Department and IRS request comments on whether a transition rule is needed and whether the Partnership Transition Amount Rule is useful or whether another approach would be more helpful in easing transition difficulties.

3. Installment Sale Gain

The proposed regulations provide that the Owner Taxpayer's One Year Gain

Amount and Three Year Gain Amount include gains from installment sales, regardless of whether the installment sale occurred before the effective date of section 1061. The proposed regulations also make clear that the holding period of the asset on the date of its disposition is used for purposes of applying section 1061. Accordingly, if an API was sold on November 30, 2017 and, at the time of its sale, it had a holding period of two years, gain recognized on or after January 1, 2018 is subject to section 1061 even though the disposition occurred before the effective date of section 1061.

This rule is consistent with the manner in which installment sales are treated under existing law.
See, e.g.
, Snell
v.
Commissioner,
97 F.2d 891 (5th Cir. 1938) (the tax laws in effect for the year the installment gain is recognized apply to the gain);
see also Estate of Kearns
v.
Commissioner,
73 T.C. 1223 (1980);
Klein
v.
Commissioner,
42 T.C. 1000 (1964); Revenue Ruling 79-22 (1979-1 C.B. 275). The holding period of the asset disposed of is the holding period on the date of disposition because section 453 defers gain recognition, not gain realization, and thus section 1061(a) applies to each year in which gain is recognized after 2017, even if the gain is recognized more than three years after the date of sale.
Estate of Henry H Rodgers
v.
Commissioner,
143 F.2d 695, 696-697 (1944).

4. Regulated Investment Company (RIC) and Real Estate Investment Trust (REIT) Capital Gain Dividends

Section 852(b)(3)(C)(i) provides generally that a RIC capital gain dividend is any dividend, or part thereof, which is reported by the RIC as a capital gain dividend in written statements furnished to its shareholders. Similarly, section 857(b)(3)(B) provides generally that a REIT capital gain dividend is any dividend, or part thereof, which is designated by the REIT as a capital gain dividend in a written notice mailed to its shareholders. The aggregate amount of capital gain dividends paid by a RIC or REIT for a taxable year, however, may not exceed the net capital gain of the RIC or REIT for that taxable year.

Section 852(b)(3)(B) provides that a RIC capital gain dividend shall be treated by the shareholders as a gain from the sale or exchange of a capital asset held for more than one year. Similarly, section 857(b)(3)(A) provides that a REIT capital gain dividend shall be treated by the shareholders as a gain from the sale or exchange of a capital asset held for more than one year.

The Treasury Department and the IRS are aware that taxpayers are concerned that section 1061(a)(2) might be read to prevent RIC and REIT capital gain dividends received by partnerships from being treated as long-term capital gains by taxpayers that hold APIs in those partnerships. Specifically, taxpayers are concerned that these dividends may not meet the three-year holding period requirement under section 1061(a) because of the specification in sections 852(b)(3)(B) and 857(b)(3)(A) that these dividends are treated as a gain from the sale or exchange of a capital asset held for more than one year. The Treasury Department and the IRS agree that long-term capital gain treatment should be available to the extent that the capital gain dividend is attributable to capital assets held for more than three years or is attributable to assets that are not subject to section 1061.

The proposed regulations address this issue by allowing a RIC or REIT to disclose two additional amounts for purposes of section 1061. The two additional amounts to be disclosed are 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 § 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 § 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.

The proposed regulations provide that partnerships that receive either or both of these additional capital gain dividend disclosures from a RIC or REIT must use each additional disclosed amount in calculating API distributive share amounts. The first additional disclosed amount is used for the calculation of an API One Year Distributive Share Amount. The second additional disclosed amount is used for the calculation of an API Three Year Distributive Share Amount. However, the proposed regulations provide that the full amount of the RIC's or REIT's capital gain dividend must be used for the calculation of an API One Year Distributive Share Amount if the first additional amount is not disclosed, and 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 if the second additional amount is not disclosed.

To prevent the avoidance of section 1061, the proposed regulations also provide that each of the two additional disclosed amounts provided 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.
Cf.
Section 857(g)(2) and Rev. Rul. 89-81, 1981-1 C.B. 226.

Additionally, in accordance with sections 852(b)(4) and 857(b)(8), the proposed regulations provide that with respect to any shares of RIC or REIT stock with respect to which a partnership receives a capital gain dividend distribution and the second additional disclosed amount that is used to calculate the API Three Year Distributive Share Amount, any loss on the sale or exchange of such shares held for less than six months will be treated as capital loss on assets held for more than three years to the extent of the second additional disclosed amount that is included in the calculation of an API Three Year Distributive Share Amount.

5. Distributed API Property

Generally, the distribution of property with respect to an API does not accelerate the recognition of gain under section 1061 or these proposed regulations. However, if Distributed API Property is disposed of by the distributee-partner when the holding period is three years or less (inclusive of the partnership's holding period), gain or loss with respect to the disposition is API Gain or Loss. Distributed API Property retains its character as it is passed from one tier to the next. However, at the time that Distributed API Property is held for more than three years, it loses its character and is no longer Distributed API Property. If Distributed API Property is distributed from one Passthrough Entity to another and the upper-tier entity disposes of the property, the long-term capital gain or loss is included in the upper-tier entity's long-term capital gain or loss as API Gain or Loss. If the property is distributed to an Owner Taxpayer and the Owner Taxpayer disposes of the property, the capital gain or loss is included in the Owner Taxpayer's API One Year Disposition Gain or Loss. This rule is necessary to prevent the avoidance of section 1061 because,

absent such a rule, section 1061 could be circumvented by the partnership's distribution of an asset to the API Holder prior to the sale of the asset in situations in which the asset has been held by the partnership for three years or less.

6. Holding Periods Used for Applying Section 1061

The Treasury Department and the IRS considered different approaches to the holding period rules. As one commentator pointed out, there are a number of different approaches that can be considered. These approaches include: (1) Using the holding period of the owner of the asset sold (whether the asset disposed of is the API itself or is an underlying capital asset held by the partnership); (2) using the Owner Taxpayer's holding period in its interest; (3) using the partnership's holding period in its assets; or (4) using the lesser of the holding period of the partnership in the assets or the Owner Taxpayer's holding period in the interest. If the holding period of the owner of the asset applies, then the partnership's holding period in the asset or the partner's holding period in the API applies (whichever is disposed of).

The proposed regulations adopt the approach that the holding period of the owner of the asset sold controls. The Treasury Department and the IRS have adopted this approach because it is the approach most consistent with subchapter K of chapter 1 of the Code and the intended application of section 1061. Additionally, this approach is also the most administrable for taxpayers and the government.

To this end, the proposed regulations provide that if a partnership disposes of an asset, it is the partnership's holding period in the asset that controls. This includes the disposition of an API by the partnership. This result is consistent with the application of section 702(b) and Revenue Ruling 68-79 (1968-1 C.B. 310) which ruled that when a partnership sells a capital asset held by the partnership for over 6 months (the then-required holding period for long-term capital gains), a new partner takes into account his distributive share of gain from the sale as long-term capital gain notwithstanding that the partner has not held its interest in the partnership long enough to qualify for long-term capital gain treatment if the partnership interest itself had been sold.

Section 741 provides that gain or loss on the sale of a partnership interest is considered as gain or loss from the sale or exchange of a capital asset except as otherwise provided in section 751. Therefore, the sale of a partnership interest generally follows an entity approach, as opposed to an aggregate approach. Following this approach, the proposed regulations provide that, except to the extent that the Lookthrough Rule described in § 1.1061-4(b)(9) and section III.E.7 of this Explanation of Provisions, applies, the holding period that an API Holder has in an API is the applicable holding period upon the disposition of an API.

The proposed regulations also provide that 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 an asset or API has been held for the long-term holding period by applying those provisions as if the applicable holding period were three years instead of one year.

These proposed regulations also amend § 1.1223-3 to clarify how to calculate the holding period of an API when the API comprises a portion of the partnership interest and the partnership interest has a divided holding period under § 1.1223-3. This clarification applies to the calculation of all profits interests and all APIs. Section 1.1223-3(a) provides that a partnership has a divided holding period if portions of the interest are acquired at different times or the partner acquired portions of the partnership interest in exchange for property transferred at the same time but resulting in different holding periods. The general rule in § 1.1223-3(b)(1) is that the portion of the interest to which the holding period relates is determined by reference to a fraction, the numerator of which is the fair market value of the portion of the partnership interest received in the transaction to which the holding period relates, and the denominator of which is the fair market value of the entire partnership interest determined immediately after the acquisition transaction. In the case of the portion of a partnership interest that is comprised in part by one or more APIs or profits interests, the proposed regulations clarify the timing of this determination as to that portion to the time immediately before the disposition (as compared to the acquisition) of all or a part of the interest. Accordingly, in the case of a partnership interest that has a divided holding period and the partnership interest includes a profits interests, the relative fair market of the profits interest is determined at the time of the interest's disposition (or partial disposition). The holding period of the portion of the interest that does not include the profits interest continues to be determined under § 1.1223-3(b)(1). No inference is intended with respect to the valuation of a profits interest that fails to meet the safe harbor under Revenue Procedure 93-27 (as clarified in Revenue Procedure 2001-43).

7. Lookthrough Rule on Sale of APIs

Generally, these proposed regulations do not look through a partnership to its assets on the sale of a partnership interest. However, the proposed regulations include a limited Lookthrough Rule that may apply to the sale of an API with a holding period of more than three years for capital gain. In the case of a disposition of a directly held API with a holding period of more than three years, the Lookthrough Rule applies if the assets of the partnership in which the API is held meet the Substantially All Test. 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 for a gain and either 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 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 Lookthrough Rule does not apply to the disposition of an API if section 1061(d) applies.

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 § 1.1061-4(b)(6) if disposed of by the partnership and have a holding period of three years or less. The determination of whether the substantially all test is met is made by expressing the value of a fraction as a percentage. The numerator of the fraction is equal to the aggregate fair market value of the partnership's assets that would produce capital gain or loss that is not described in § 1.1061-4(b)(6) if disposed of by the partnership and that have a holding period of three years or less to the partnership as of the date of disposition of the API. The denominator is equal to the aggregate fair market value of the partnership's assets. Cash, cash equivalents, unrealized receivables under section 751(c), and inventory items under section 751(d) are not taken into account for purposes of the Substantially All Test.

In the case of a disposition of an API by an API Holder that is an Owner Taxpayer, all of the long-term capital gain recognized on the disposition is included in the API One Year Disposition Amount. The amount included in the API Three Year Disposition Amount with respect to the disposition is the amount included in the API One Year Disposition Amount reduced by any adjustment amount required by the Lookthrough Rule. In the case of a disposition of an API by an API Holder that is a Passthrough Entity to which the Lookthrough Rule applies, the long-term capital gain recognized on the sale is included in the API One Year Distributive Share Amount calculated for the API Holders of the Passthrough Entity. Section 1.1061-4(a)(3) provides that the API Three Year Distributive Share Amount is reduced by the adjustment amount required by the Lookthrough Rule. The adjustment amount required by the Lookthrough Rule is either the capital gain recognized on the disposition of the API that is attributable to the assets whose fair market value is included in the numerator of the fraction used for the Substantially All Test, or, in the case of an API indirectly held through a Passthrough Entity for three years or less, the gain attributable to the API.

IV. Transfers to Related Parties

A. Recognition and Recharacterization

Under section 1061(d), if a taxpayer transfers an API to a related person described in section 1061(d)(2) in a transfer that would not otherwise be a taxable event, the taxpayer must include certain capital gain in gross income as short-term capital gain. The amount of gain required to be included as short-term capital gain is the excess of the net built-in long-term capital gain in assets held for three years or less attributable to the transferred interest, over the amount of long-term capital gain recognized on the transfer that is treated as short term capital gain under section 1061(a). If the transfer is otherwise taxable, section 1061(d) recharacterizes all or a portion of the capital gain otherwise recognized on the transfer as short-term capital gain. If the amount of capital gain otherwise recognized by the taxpayer on a taxable transfer is less than the amount required to be included under section 1061(d), the taxpayer must include the difference as short-term capital gain under section 1061(d). The proposed regulations refer to a related person described in section 1061(d)(2) as a
Section 1061(d) Related Person.

One commentator suggested that the Treasury Department and the IRS suspend the application of section 1061(d) until Congress clarifies its application. The Treasury Department and the IRS do not believe a suspension is necessary. Rather, the Treasury Department and the IRS interpret section 1061(d)(1) to require that gain equal to the amount described in that section be recognized and included in income as short-term capital gain on the transfer of an API to a Section 1061(d) Related Person even if the transfer is not a transaction in which gain is otherwise recognized under the Code. The term transfer under the proposed regulations includes, but is not limited to, contributions, distributions, sales and exchanges, and gifts.

B. Section 1061(d) Related Person

Section 1061(d)(2) defines a related person to be a member of the taxpayer's family within the meaning of section 318(a)(1) or a person who performed a service within the current calendar year or the preceding three calendar years in any ATB in which or for which the taxpayer performed a service. The Conference Report describes a Section 1061(d) Related Person as a family member or colleague (or recent former colleague). Conference Report at 422. For these purposes, a taxpayer is the same taxpayer used for computation purposes (as opposed to the taxpayer used for determining whether the elements of an API are met), that is, an Owner Taxpayer. The proposed regulations clarify that for a service provider to be treated as a Section 1061(d) Related Person, the service provider must provide services or have provided services in the same ATB to which the transferred API relates, that is, in the Relevant ATB. The proposed regulations also include within the definition of Section 1061(d) Related Person any Passthrough Entity to the extent that a Section 1061(d) Related Person holds an interest. The Treasury Department and the IRS request comments on how to calculate section 1061(d) gain when a Passthrough Entity is only partially a Related Person.

The proposed regulations provide that a contribution under section 721(a) to a partnership is not treated as a transfer to a Section 1061(d) Related Person because the proposed regulations require that under the principles of section 704(c) and §§ 1.704-1(b)(2)(iv)(f) and 1.704-3(a)(9) all Unrealized API Gains that would be directly or indirectly allocated to the API Holder at the time of contribution must be allocated to the API Holder contributing the interest when they are recognized. The Treasury Department and the IRS request comments on transfers other than section 721(a) contributions that satisfy the foregoing standard and that therefore should be excluded from section 1061(d).

The proposed regulations use the term “person” as the term is generally used under section 7701(a)(1). Section 7701(a)(1) defines “person” to include an individual, trust, estate, partnership, association, company, or corporation. Under the section 7701(a)(1) definition of person, for example, a management company could qualify as a related person under section 1061(d)(2) because the management company would have performed a service in the same ATB in which the taxpayer had performed a service in the three years preceding the transfer.

C. Gain Recharacterized by Section 1061(d)

Section 1061(d)(1) requires the taxpayer to include as short-term capital gain the excess of the taxpayer's long-term capital gain with respect to such interest for such taxable year attributable to the sale or exchange of any asset held for not more than three years as is allocable to such interest over any amount treated as short-term capital gain with respect to the transfer of the interest under section 1061(a).

The proposed regulations provide that the long-term capital gain with respect to the transferred API attributable to the sale or exchange of any asset held not more than three years is the long-term capital gain that would be allocated to the transferred API if, immediately before the transfer, the partnership that issued the API had sold all of its assets held for three years or less for fair market value in a hypothetical sale. If the result is negative, the result is deemed to be zero and section 1061(d) does not apply.

The proposed regulations provide that if the basis of the transferred API in the transferee's hands is determined in whole or in part by the basis of the API in the transferor's hands before application of section 1061(d), then the basis of the transferred API shall be increased (before the application of section 1015(d), if applicable) by the capital gain included in gross income by the transferor solely by reason of section 1061(d). If an Owner Taxpayer transfers only a portion of an API, section 1061(d) applies only to the portion transferred.

V. Securities Partnerships

The proposed regulations include an amendment to § 1.704-3(e)(3). Section 1.704-3(e)(3)(i) provides that for purposes of making reverse section

704(c) allocations, a securities partnership may aggregate gains and losses from financial assets using any reasonable approach that is consistent with the purpose of section 704(c). The proposed regulations amend § 1.704-3(e)(3) to provide that an approach will not be considered reasonable if it fails to take into account the application of section 1061. Additionally, the proposed regulations provide that if the partnership aggregates gains and losses with respect to capital assets held for more than one year, for the partial netting approach in § 1.704-3(e)(3)(iv) and the full netting approach in § 1.704-3(e)(3)(v) to be considered reasonable, the partnership must establish separate accounts (1) for taking into account each API Holder's share of book API Gains and Losses and book Capital Interest Gains and Losses and (2) for determining each API Holder's share of tax API Gains and Losses and tax Capital Interest Gains and Losses. The proposed regulations do not include rules for dividing existing accounts to determine API Gains and Losses and Capital Interest Gains and Losses. However, the proposed regulations provide that the manner in which such accounts are apportioned must be reasonable. One method that the Treasury Department and the IRS have concluded is reasonable is to apportion existing accounts based on the relative API Gain or Loss amounts and Capital Interest Gain or Loss amounts that would be allocated to the API Holder as a result of a deemed liquidation of the partnership. The Treasury Department and the IRS request comments on whether further guidance on this issue is necessary for securities partnerships using the aggregation rules in § 1.704-3(e)(3).

VI. Reporting Requirements

These proposed regulations provide that an Owner Taxpayer must report any information the Commissioner may require in forms, instructions or other guidance to evidence the taxpayer's compliance with section 1061. Under the proposed regulations, a Passthrough Entity in which an Owner Taxpayer holds its interest is required to provide the information needed by the Owner Taxpayer to comply with section 1061 and to determine its Recharacterization Amount. The Passthrough Entity is required to provide the Owner Taxpayer with the API One Year Distributive Share Amount and the API Three Year Distributive Share Amount. Additionally, the Passthrough Entity must provide the Owner Taxpayer with the adjustments that must be made to the Owner Taxpayer's distributive share of long-term capital gain or loss that would allow the Owner Taxpayer to independently calculate its API One Year Distributive Share Amount and its API Three Year Distributive Share amount. Consistent with § 1.6001-1(a) and (e), if an Owner Taxpayer is not furnished its API One Year Distributive Share Amount, the IRS will treat the amount of the adjustments necessary to independently calculate the API One Year Distributive Share as zero and will also treat the API Three Year Distributive Share as zero to the extent information is not provided to the Owner Taxpayer and the Owner Taxpayer is not able to otherwise substantiate all or a part of those amounts to the satisfaction of the Secretary. For example, if the Owner Taxpayer is not furnished its API One Year Distributive Share Amount, the IRS will not take into account amounts that are excluded from section 1061 under § 1.1061-1(b)(6) unless the Owner Taxpayer is furnished information regarding this amount or the Owner Taxpayer is otherwise able to substantiate this amount. Similarly, if the Owner Taxpayer is not furnished its API Three Year Distributive Share Amount, to the extent that the Owner Taxpayer is also not furnished information regarding items that are not treated as long term capital gain or loss if paragraphs (3) and (4) of section 1222 required a three year holding period for long-term capital gain treatment, the IRS will treat the API Three Year Distributive Share Amount as zero if the taxpayer cannot otherwise substantiate this amount. An Owner Taxpayer that takes a position that is inconsistent with the information provided to it by a Passthrough Entity may have to attach Form 8082, “Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR),” to its federal income tax return.

A Passthrough Entity that has an API Holder must report information to the API Holder to enable the API Holder to comply with the regulations under section 1061 as the Commissioner may require in forms, instructions, or other guidance. It is contemplated that the Passthrough Entity generally will be required to provide this information as an attachment to the Schedule K-1 furnished to the API Holder for the taxable year. The proposed regulations provide that this information includes (i) the API One Year Distributive Share Amount and the API Three Year Distributive Share Amount; (ii) long-term capital gains and losses allocated to the API Holder that are excluded from section 1061 under § 1.1061-4(b)(6); (iii) Capital Interest Gains and Losses allocated to the API Holder; (iv) API Holder Transition Amounts; and (v) in the case of a disposition by an 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 regarding the application of Lookthrough Rule and information necessary to determine its Capital Interest Disposition Amount. Penalties will apply to a Passthrough Entity that fails to comply with the reporting rules in these proposed regulations and as further required in forms, instructions or other guidance.
See e.g.,
section 6698 (Failure to File Partnership Returns), section 6699 (Failure to File S Corporation Return), section 6722 (Failure to Furnish Correct Payee Statements).

A Passthrough Entity that holds an interest in a lower-tier entity may need information from the lower-tier entity to meet its reporting obligations under the proposed regulations. In this case, the Passthrough Entity must request information from any lower-tier entities in which it owns an interest by the later of the 30th day of the close of the calendar year or within 14 days after having received a request for information from an API Holder. The lower-tier entity must respond by the due date (including extensions) of the Schedule K-1 for the taxable year. The proposed regulations provide guidance regarding an upper-tier Passthrough Entity's reporting requirements if the lower-tier Passthrough Entity fails to report the required information to the upper-tier Passthrough Entity.

VII. Applicability Date

The proposed regulations generally provide that the final regulations apply to taxable years of Owner Taxpayers and Passthrough Entities beginning on or after the date final regulations are published in the
Federal Register
. However, except for the rules in the proposed regulations regarding Partnership Transition Amounts and API Holder Transition Amounts, Owner Taxpayers and Passthrough Entities may rely on the proposed regulations for taxable years beginning before the date final regulations are published in the
Federal Register
provided they follow the proposed regulations in their entirety) and in a consistent manner. In contrast, taxpayers may rely on the rules in the proposed regulations regarding Partnership Transition Amounts and API Holder Transition Amounts for taxable years beginning in 2020 and subsequent taxable years beginning

before the date final regulations are published in the
Federal Register
, and may do so without consistently following all of the rules provided in §§ 1.1061-1 through 1.1061-6 of these proposed regulations if the partnership treats capital gains and losses from the identified assets as Partnership Transition Amounts and API Holder Transition Amounts for the year in which the election is made and all subsequent taxable years beginning before the date final regulations are published in the
Federal Register
.

As indicated in section 4 of Notice 2018-18, proposed § 1.1061-3(b)(2)(i), which provides that the term corporation does not include an S corporation, is proposed to apply to taxable years beginning after December 31, 2017.
See
section 7805(b)(3). Additionally, proposed § 1.1061-3(b)(2)(ii), which provides that the term corporation does not include a PFIC with respect to which the shareholder has a QEF election under section 1295 in effect, is proposed to apply for taxable years beginning after August 14, 2020.

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 section 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 that has a year end after December 31, 2017, section 1061 applies to the Owner Taxpayer's d

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2020-17108. Public record. Not legal advice.