Carried interests have been in the news a lot lately, and they apply only to a select group of taxpayers. A carried interest is any profits interest received as compensation by employees or partners of a partnership. The value in the carried interest lies in the future value of the partnership. If the value of the partnership increases, the value of the carried interest also increases. When the holder of the interest disposes of it, any gain is subject to capital gain rates of taxation, as opposed to ordinary income rates. So, if you do not issue carried interest or your employer does not issue carried interests, this law change will not apply to you!

Elements of reporting requirements for Section 1061 – which originated from the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) – begin to take effect for tax years beginning on or after Jan. 19, 2021. The law change means additional holding requirements and reporting requirements for certain entities that are held by taxpayers of carried interests.

Section 1061 recharacterizes certain net long-term capital gains of a partner that holds one or more applicable entity interests in a pass-through entity as short-term capital gains. It requires that a capital asset be held for more than three years for the capital gain allocated to any applicable entity interest holder to be treated as a long-term capital gain. To know specifically which interests Section 1061 affects, it helps to understand the key terms:

  • An applicable passthrough interest or “API” is an interest in a pass-through entity’s income, gains, and losses that is held in connection with the “performance of substantial services” for the pass-through entity. This is commonly referred to as a carried interest and is normally awarded to the recipient without taxable consequences at the award date.
  • A pass-through entity with regards to Section 1061 can be a partnership, trust, estate, S-corporation, or a passive foreign investment company.
  • An applicable entity interest holder can be an individual, estate or trust. Also known as an “API holder” or “owner taxpayer.”

Prior to the enactment of Section 1061, capital gains from an entity that were held for more than one year would be taxed at preferential long-term capital gain rates similar to other types of long-term capital gains. The Section 1061 regulations have changed the long-term capital gain tax treatment for those that hold an “applicable entity interest” (i.e., a carried interest) to only apply to gains on capital assets sold by the underlying entity that are held more than three years.

To report for Section 1061, the pass-through entity is required to attach Section 1061 Worksheet A to the API holder’s Schedule K-1 for tax returns filed after Dec. 31, 2021 (2022 returns typically, but the entity may elect to attach to a 2021 tax return also). The pass-through entity must reference the attachment to the proper K-1 box and code: box 20, code AH for partnerships; box 17, code AD for S-corporations and box 14, code Z for trusts and estates.

The Owner Taxpayer uses the information provided by all of the pass-through entities of which they hold an API ‒ directly or indirectly ‒ to determine the amount that is recharacterized as short-term capital gain. The Owner Taxpayer includes long-term and short-term API gains and losses on Schedule D and on Form 8949, as if Section 1061 does not apply.

If the Owner Taxpayer has a recharacterization amount the Owner Taxpayer will increase the reported short-term capital gain. This is reported as a “Section 1061 Adjustment” on Form 8949. The Owner Taxpayer will make a corresponding entry to reduce the reported long-term capital gain as a “Section 1061 Adjustment” on Form 8949.

The entire reporting process is complicated as are the regulations under section 1061. If you have any questions concerning this new law, please contact Stanfield + O’Dell for assistance.