Tax Tip Podcast or Blog Post and Trade or Business Subject to Carried Interest Rules with Examples (Code Section 1061)

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Trade or Business Subject to Carried Interest Rules with Examples (Code Section 1061)

The Carried interest rule in Code Section 1061 applies to the performance of services in an applicable trade or business. The term “applicable trade or business” (ATB) means any activity conducted on a regular, continuous, and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of:

(1) raising or returning capital; and

(2) either (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition), or (ii) developing specified assets (Code Section 1061(c)(2)).

Proposed Regulation Section 1.1061-1(a) provides that an ATB is any activity for which the ATB Activity Test with respect to Specified Actions is met, and includes all Specified Actions taken by Related Persons, including combining activities occurring in separate partnership tiers or entities as one ATB. The ATB Activity Test is defined in Proposed Regulation Section 1.1061-2(b)(1) as being satisfied if

Specified Actions are conducted by one or more Related Persons and the total level of activity, including the combined activities of all Related Persons, satisfies the level of activity that would be required to establish a trade or business under Code Section 162 (Proposed Regulation Section 1.1061-2(b)(1)).

The determination of whether the ATB Activity Test is satisfied is based on the combined activities conducted that qualify as either Raising or ReturningCapital Actions and Investing or Developing Actions. The fact that either Raising or Returning Capital Actions or Investing or Developing Actions are only infrequently taken does not preclude the test from being satisfied if the combined Specified Actions meet the test (Proposed Regulation Section 1.1061-2(b)(1)(i)(A)).

Raising or Returning Capital Actions and Investing or Developing Actions are not both required to be taken in each taxable year. Raising or Returning Capital Actions and Investing or Developing Actions are not both required to be taken in each taxable year in order to satisfy the ATB Activity Test. For example, the ATB Activity Test will be satisfied if Investing or Developing Actions are not taken in the current taxable year, but sufficient Raising or Returning Capital Actions are taken in anticipation of future Investing or Developing Actions. Additionally, the ATB Activity Test will be satisfied if no Raising or Returning Capital Actions are taken in the current taxable year, but have been taken in a prior taxable year (regardless of whether the ATB Activity Test was met in the prior year), and sufficient Investing or Developing Actions are undertaken by the taxpayer in the current taxable year (Proposed Regulation Section 1.1061-2(b)(1)(i)(B)).

If a Related Person(s) (within the meaning of Proposed Regulation Section 1.1061-1(a)) solely or primarily performs Raising or Returning Capital Actions and one or more other Related Person(s) solely or primarily performs Investing or Developing Actions, the combination of the activities performed by these Related Persons will be taken into account in determining whether the ATB Activity Test is satisfied (Proposed Regulation Section 1.1061-2(b)(1)(i)(C)(1)).

Specified Actions taken by an agent or a delegate in its capacity as an agent or a delegate of a principal will be taken into account by the principal in determining whether the ATB Activity Test is satisfied with respect to the principal. These Specified Actions are also taken into account in determining whether the ATB Activity test is satisfied by the agent or the delegate (Proposed Regulation Section 1.1061-2(b)(1)(i)(C)(2)).

Developing Specified Assets takes place if it is represented to investors, lenders, regulators, or other interested parties that the value, price, or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider. Merely exercising voting rights with respect to shares owned or similar activities do not amount to developing Specified Assets (Proposed Regulation Section 1.1061-2(b)(1)(ii)).

Investing or Developing Actions directly conducted with respect to Specified Assets held by a partnership are counted towards the ATB Activity Test. Additionally, a portion of the Investing or Developing Actions conducted with respect to the interests in a partnership that holds Specified Assets is counted towards the ATB Activity Test. This portion is the value of the partnership’s Specified Assets over the value of all of the partnership’s assets. Actions taken to manage a partnership’s working capital will not be taken into account in determining the portion of Investing or Developing Actions conducted with respect to the interests in the partnership (Proposed Regulation Section 1.1061-2(b)(1)(iii)).

Example 1: During the tax year, Joey Bagofdonuts takes a small number of actions to raise capital for new investments. Joey takes numerous actions to develop Specified Assets. Joey’s actions with respect to raising capital and B’s actions with respect to developing Specified Assets are combined for the purpose of determining whether the ATB Activity Test is satisfied.

Example 2: GP, a partnership, conducts Raising or Returning Capital Actions. Management Company, a partnership that is a Related Party to GP, conducts Investing or Developing Actions. When GP’s and Management Company’s activities are combined, the ATB Activity Test is satisfied. Accordingly, both GP and Management Company are engaged in an ATB, and services performed by either GP or Management Company are performed in an ATB.

Example 3: In 2021, PRS engaged in Raising or Returning Capital Actions to fund PRS’s investment in Specified Assets. However, PRS’ Specified Actions during 2021 did not satisfy the ATB Activity Test because they did not satisfy the level of activity required to establish a trade or business under Code Section 162. Therefore, PRS was not in engaged in an ATB in 2021. In 2022, PRS engaged in significant Investing or Developing Actions but did not engage in any Raising or Returning Capital Actions. In 2022, PRS’s Investing or Developing Actions alone satisfy the ATB Activity Test. Therefore, PRS is engaged in an ATB in 2022.

Example 4: In 2021, Al spent all of his time on Raising or Returning Capital Actions. Al’s Raising or Returning Capital Actions were undertaken to raise capital to invest in Specified Assets with the goal of increasing their value through Investing or Developing Actions. Al did not take Investing or Developing actions during the tax year. Al’s Raising or Returning Capital Actions alone satisfy the ATB Activity Test. Therefore, the ATB Activity Test is satisfied, and Al is engaged in an ATB in 2021.

Example 5: GP is the general partner of PRS. GP is responsible for providing management services to PRS. GP contracts with Management Company to provide management services on GP’s behalf to PRS. GP and Management Company are not Related Persons. The Specified Actions taken by Management Company on behalf of GP are attributed to GP for purposes of the ATB Activity Test because the Management Company is operating as a delegate of the GP. Additionally, those Specified Actions are taken into account by Management Company for purposes of the ATB Activity Test and whether it is engaged in an ATB.

Example 6: Al is the manager of a hardware store. ABC Partnership owns the hardware store, including the building in which the hardware business is conducted. In connection with Al’s services as the manager of the hardware store, a profits interest in ABC is transferred to Al. ABC’s business involves buying hardware from wholesale suppliers and selling it to customers. The hardware is not a Specified Asset. Although real estate is a Specified Asset if it is held for rental or investment purposes, ABC holds the building for the purpose of conducting its hardware business and not for rental or investment purposes. Therefore, the building is not a Specified Asset as to ABC. ABC also maintains and manages a certain amount of working capital for its business, but actions with respect to working capital are not taken into account for the purpose of determining whether the ATB Activity Test is met. ABC is not a Related Person with respect to any person who takes Specified Actions. ABC is not engaged in an ATB because the ATB Activity Test is not satisfied. Although ABC raises capital, its Raising or Returning Capital Actions alone do not satisfy the ATB Activity Test. Further, ABC takes no Investing or Developing Actions because it holds no Specified Assets other than working capital. ABC is not in an ATB and the profits interest transferred to Al is not an API.

Brenda Fitch Real Estate Professional
Brenda Fitch Real Estate Professional

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(Updated 04/18/2021 07:46)

Trade or Business Subject to Carried Interest Rules with Examples (Code Section 1061)

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