Start-Ups May Be Hurt by Carried Interest Regs, Venture Capitalists Say

October 5, 2020

The Honorable David Kautter
Assistant Secretary of the Treasury (Tax Policy)
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

The Honorable Michael Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

CC:PA:LPD:PR (REG-107213-18)
Room 5203
Internal Revenue Service
POB 7604, Ben Franklin Station
Washington, DC 20044

RE: Comments on Section 1061 Proposed Regulations Related to Recharacterization of Certain Long-term Capital Gains Attributable to an Applicable Partnership Interest (REG-107213-18)

Dear Sirs:

The National Venture Capital Association (NVCA) appreciates the opportunity to provide comments on the section 1061 proposed regulations related to the recharacterization of certain long-term capital gains attributable to an applicable partnership interest (“API”).

Our members manage venture capital funds that invest in thousands of startup and early-stage companies each year. Investment by NVCA members empower the next generation of American companies that will fuel the economy of tomorrow. According to data from the U.S. Department of Labor and the U.S. Census Bureau, new businesses create an average of three million jobs each year. Venture capital is vital to this job growth, as a recent Stanford University study has shown that 42 percent of the companies that have gone public between 1974 and 2015 had venture capital investment. Further, companies previously backed by venture capital account for 85 percent of research and development spending by companies that have gone public since 1974.¹

Venture capital investment allows companies to conduct research, develop novel products, hire new staff, expand into additional markets, and undertake other growth activities. Venture capital investors are patient and understand the natural business cycle of growth companies is long-term. As the voice of the U.S. venture capital and startup community, NVCA advocates for public policy that promotes new company formation and the American entrepreneurial ecosystem.

Therefore, while we greatly appreciate Treasury and the IRS's efforts to provide guidance in this important area, we want to comment on several features in the proposed regulations that we believe would hinder investment in start-up and early-stage growth companies.

Specifically, modifications are needed in the following areas to avoid recharacterizing long-term capital gains in a manner that is either not authorized or unwarranted: (1) the capital interest exception should more closely conform to the statute and ensure that section 1061 does not recharacterize an API Holder's return on capital investment (i.e., by allowing the taxpayer to share in a partnership's allocations commensurate with his or her capital contribution and generally counting contributions funded with the proceeds of loans with adequate security for purposes of the exception); (2) the look-through rule applicable to indirectly-held APIs should be modified generally to be consistent with the look-through rule applicable to directly-held APIs; and (3) the related party transfer rule should not apply to built-in gain, and consistent with the statute, should only require recharacterization when there has been recognition of long-term capital gains attributable to a sale or exchange of an asset held for three years or less.

We also believe the information reporting rules should be amended to be less burdensome, to remove penalties associated with noncompliance causing taxpayers to lose eligibility for applicable exclusions from recharacterization, and to provide a delayed effective date to provide sufficient time for taxpayers to come into compliance.

Each of these issues is described in more detail below. Our comments are intended to help ensure that the regulations do not create unintended tax consequences that would increase complexity, reduce the attractiveness of startup investment, and create barriers to entry for the next generation of American venture capitalists.

The capital interest exception

Section 1061 recharacterizes certain gains attributable to an API as short-term capital gains if the assets are not held for at least three years. Section 1061(c)(4)(B)(i) provides an exception from treatment as an API for a capital interest providing the partner a right to share in the partnership capital commensurate with the amount of capital contributed, determined at the time of the receipt of the capital interest.

In contrast to the statute, the proposed regulations base the capital interest exception on allocations being commensurate with capital accounts, rather than capital contributions. Specifically, under the proposed regulations, capital interest allocations will be excluded from section 1061 only if such allocations are “based on capital account balances” and meet the following requirements: (1) they are made in the same manner to API Holders and Unrelated Non-Service Partners,² (2) the allocations are made to Unrelated Non-Service Partners with a significant aggregate capital account balance (an aggregate capital account balance equal to five percent or more of the partnership's aggregate account balance at the time the allocations are made will be considered significant), and (3) the allocations to the API Holder and Unrelated Non-Service Partners are clearly identified both under the partnership agreement and on the partnership's books and records.³ If a capital interest allocation does not meet the test, then none of the amount allocated to the API Holder is eligible for the capital interest exception.

We believe the capital account approach in the proposed regulations is unworkable in the context of a traditional venture capital fund structure and will deny the capital interest exception to most common venture capital fund arrangements where an API Holder has contributed capital, resulting in an inappropriate recharacterization of a taxpayer's return on capital investment. This result puts the regulations in conflict with the statute, which clearly excludes any allocations that are “commensurate with the amount of capital contributed” from application of section 1061.

To help understand why the capital account approach is unworkable in the context of a traditional venture capital fund structure, we would like to review quickly how a traditional venture capital fund operates. Unlike hedge funds, traditional venture capital funds are “closed-end” funds, meaning that they admit investors for a short period of time, after which no further investors are admitted to, or allowed to withdraw from the fund. As a result of this closed-end structure, typically each investor's share of allocations is based on their capital commitment percentage, not their capital account. This is best illustrated through an example:

GP forms a limited partnership (“VC-PRS”) and commits to contribute $200 (2 percent) to PRS. Investors commit to contribute $9800 (98 percent) to VC-PRS. The partnership agreement of VC-PRS provides that allocations are effected 20 percent to GP, with the remaining 80 percent allocated to investors and GP based on their respective capital commitments (as a result, GP is entitled to receive 2 percent of such 80 percent, or an additional 1.6 percent of PRS profits).

Note that the simple example above describes the prototypical venture capital fund structure. In this fact pattern, it is abundantly clear that the 1.6 percent of profits that are allocable to GP should be treated as capital interest allocations. No more should be treated as capital interest allocations and no less, yet because the proposed regulations require that capital interest allocations must be based on “capital accounts”, and the agreement of VC-PRS bases allocations on capital commitments, it appears that no share of GP's gains could be treated as capital interest allocations.

Even if the proposed regulations no longer require that capital interest allocations be based on capital accounts, the requirements in the proposed regulations that capital interest allocations be clearly identified as such, and that they must be made to API Holders and Unrelated Non-Service Partners, elevates form over substance. Again, referring to the Example, the GP receives 21.6 percent of profits overall. The GP should not receive a different tax result with respect to its 1.6 percent allocation depending on whether the VC-PRS partnership agreement is drafted with a single 21.6 percent allocation to the GP, or instead provides for a 20 percent allocation followed by a 2 percent allocation of the remaining 80 percent (as set forth in Example 1). Elevating form over substance is particularly problematic in the VC industry, where the long-term nature of startup investing means many partnerships have effective terms of 15 years. Imposing a form-over-substance set of rules on taxpayers who can no longer adjust the form of their agreements (because they were negotiated with investors many years ago) will impose an unfair hardship on these taxpayers.

As noted above, in the case of a closed-end fund such as a venture capital fund, the combination of dictating that capital interest allocations be determined based on capital accounts, along with the elevation of form over substance, will result in unfair distinctions between economically equivalent arrangements.

The approach adopted by the proposed regulations will result in inequities in a number of other circumstances in the venture capital context that may not arise in the hedge fund context. For example, it is common in venture capital funds for partners to be able to opt out of certain investments, particularly investments that would cause those partners to have regulatory issues. Consequently, the partners' share of relative allocations will vary based on a deal-by-deal basis, rather than based on a single metric such as capital account balances or even aggregate capital contributions. In such a case, the all-or-nothing test in the proposed regulations could result in an API Holder being subject to recharacterization on any allocations with respect to its capital investment in the fund. A similar issue arises when a fund allows new partners to contribute capital upon a new capital call, as is commonplace in venture capital, and this will cause the allocations to the partners based on capital accounts to vary.

Due to the several issues stated above, we recommend that the proposed regulations be modified to allow taxpayers to use any reasonable benchmark to demonstrate that the capital interest allocations are commensurate with the amount of capital contributed by the API Holder. In that regard, we recommend that a safe-harbor be established whereby to the extent that a partnership agreement requires an API Holder to make capital contributions to a partnership at the same time and in a percentage that is no less than a specified percentage of the amount of capital invested by all partners of such partnership (e.g. the 2% GP commitment in the example above), then allocations of up to such specified percentage of items of partnership income or gain will be treated as capital interest allocations (in other words, in the example above, allocations of up to 2% of partnership income or gain to the GP will be treated as capital interest allocations).

Treatment of loans from partners, the partnership, and the partnership's related parties

An additional concern is that, under the proposed regulations, capital contributed that is directly or indirectly attributable to any loan or advance made or guaranteed by any other partner, the partnership, or any related person to such partner or the partnership will not be included in capital accounts for purposes of the capital interest exclusion until the loan is repaid.

We believe that this treatment of loans inhibits common and reasonable business practices that are not abusive. The rule in the proposed regulations will create an additional barrier to entry for the next generation of American venture capitalists without significant liquid net worth, reducing access to opportunity and harming efforts to increase diversity in the startup ecosystem.

Unlike prior carried interest proposals, there is no reference to related party or partner loans in section 1061 or the legislative history. The rule in the proposed regulations is similar to language in the bill sponsored by former Congressman Levin, which was expressly considered and rejected by both tax-writing committees during the TCJA legislative process.⁴

It is common market practice for younger service partners to either borrow from more senior partners or to borrow from a third party guaranteed by the partnership to buy into the investment fund. This arrangement allows individuals with less access to their own capital to participate in venture capital, allowing them to be personally invested in the funds they are managing, aligning their interests with investors by sharing in the risks, and providing them an opportunity to participate in any economic growth they help to create. Often, significant capital commitments are required of general partners by the limited partners in the fund. The proposed regulations would penalize use of such common business arrangements, even though the loan is fully recourse to the partner or is non-recourse with adequate security.

While there may be concerns where loans are both non-recourse and unsecured, we believe the risk for abuse does not exist when the loan is at market rates and the borrowing taxpayer is personally liable or the loan is otherwise adequately secured. Moreover, it is important to note there are already other rules in statute and regulations (e.g. section 7872 and reg. section 1.83-3(a)(2)) that recharacterize below-market or unsecured loans as compensation, an option or a gift. Thus, given those rules will apply to taxpayers impacted by section 1061, it is not clear why an additional set of rules are necessary in this context to prevent any perceived abuse.

Therefore, we believe the proposed regulations should be modified to allow non-abusive common practices where capital contributions are made with the proceeds of a recourse loan, non-recourse loan with adequate security, or a third-party loan guaranteed by the partnership to count for purposes of the capital interest exception.

Look-through Rule for Indirect APIs

Under the proposed regulations, when a taxpayer disposes of a directly-held API, its holding period in the partnership interest generally controls (i.e., in general, it is not required to look-through to the holding period of the partnership's assets). However, an exception applies that requires a taxpayer disposing of a directly-held API to look through to the underlying assets, if at least 80 percent of the partnership's assets, based on fair market value, would produce capital gain or loss that is not described in proposed reg. §1.1061-4(b)(6) and have a holding period of three years or less (referred to as the “substantially all test”).⁵ We believe this treatment of directly-held APIs is an appropriate and balanced approach: taxpayers are allowed LTCG treatment for dispositions of long-held partnership interests, unless the disposition of the interest is effectively being used to avoid section 1061 recharacterization on the bulk of the underlying assets.

Unfortunately, the application of the look-through rule for indirectly-held APIs does not operate in a similar fashion. Rather, in many cases, it effectively turns off the general rule and requires that the taxpayer look-through to the holding period of the indirectly-held API or to the holding period of the assets if the pass-through entity in which the API is held meets the substantially all test. It would cause some of the gain on the sale of an upper-tier investment services firm that has been held for well over three years to be treated as short-term capital gain, even though most of the value is not attributable to assets held for three years or less. Moreover, while this rule acts somewhat similar to a “hot asset” rule under section 751, its application is not limited to the value of the underlying assets of the fund, but it also captures gain on the going-concern value inherent in the fund itself. As a result, owners of such investment firms are taxed at higher rates on some of their enterprise value, treating them worse than owners of other businesses.

Therefore, to avoid this unfair result and the disparate treatment between directly-held APIs and indirectly-held APIs, we recommend that Treasury and the IRS apply a look-through rule applicable to indirectly-held APIs that is similar to the one provided for directly-held APIs. This could be accomplished through providing a substantially all test in which the transferring taxpayer who has held its interest for greater than three years will only be required to look through to the underlying assets' character if 80 percent or more of the assets held directly or indirectly by the pass-through entity have a holding period of fewer than three years.

Related party transfers

Section 1061(d) provides that if a taxpayer transfers an API to a related person, the taxpayer shall include in gross income 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 under 1061(a) with respect to the transfer of such interest” (emphasis added). Thus, the statutory rule for related party transfers is clear and only imposes recharacterization to the extent there is otherwise recognized long-term capital gains.

The proposed regulations go further than what is authorized by the statute by requiring taxpayers transferring an API to a related party to recognize unrealized built-in gains. Specifically, the proposed regulations require a taxpayer transferring an API to a related person (as defined in section 1061(d) and prop. reg. section 1.1061-5(e)) to recognize short-term capital gain in an amount equal to the excess of (i) the net built-in long-term capital gain in assets held for three years or less attributable to the transferred interest, over (ii) the amount of long-term capital gain recognized on the transfer that is treated as short-term capital gain under section 1061(a).⁶ No such tax on built-in gains was contemplated by Congress. By imposing a tax on gain from appreciated assets that have not been recognized, the proposed regulations go well beyond the language in the statute, which: (i) applies the income inclusion and recharacterization only to the taxpayer's “long-term capital gain” and (ii) requires that the gain must be “attributable to the sale or exchange of any asset.”

This will make it very difficult to effect necessary normal business transactions with no potential for abuse. For example, it is very common for a new recruit to a venture capital firm to be granted an interest in an existing partnership. The proposed regulations would cause an API Holder who transferred a portion of his interest to a new recruit as recognizing immediate gain on the inherent value in the relinquished interest, even though the transferred interest will remain an API in the hands of the new recruit. Moreover, the original API Holder has neither realized nor recognized any economic gain or accretion to wealth, and given the high-risk nature of startup investment, may never realize any gain from the asset.

Consistent with the statute, the proposed regulations' related party rule should be limited to circumstances in which the taxpayer transferring the API actually has long-term capital gains attributable to the sale or exchange of an asset allocable to the API. If there is no long-term capital gain, then the section 1061(d) related party rule should not apply.

We respectfully request that the related party rules be modified to require recharacterization upon a transfer to a related party only when there is recognized long-term capital gain “attributable to the sale or exchange of any asset” held for three years or less allocable to the API.

Reporting requirements

We appreciate the government's challenge, given the language of the statute, to ensure that all Owner Taxpayers and API Holders have the necessary information to make section 1061 determinations. However, we believe that the rules as constructed are overly burdensome and will unfairly cause some taxpayers to lose exclusions from recharacterization. The proposed regulations provide a severe penalty for non-compliance by removing eligibility for exclusions (i.e., generally disallowing long-term capital gains treatment) if the reporting requirements are not satisfied. There is no indication in the statute or legislative history that this is what Congress intended.

Although the statute is silent, the TCJA conference report indicates that Congress intended for penalties applicable to a failure to report to partners under section 6031(b) to apply to a failure to report under the section 1061 requirements. Section 6031(b) generally requires partnerships to furnish a copy of the return to each partner on or before the return's due date. Penalties for failure to comply with section 6031 are provided in sections 6698, 6722, and 7203. These penalties are significant and sufficient to deter non-compliance by themselves and none of them act to change the character of distributive share items.

Further, the regulations require upper-tier partnerships and Owner Taxpayers to request from lower-tier partnerships information related to one-year and three-year distributive share amounts, capital gains and losses allocated to the API Holder that are excluded from 1061, and other amounts. This information must be filed with the IRS by both the pass-through entity and the Owner Taxpayer. The Owner Taxpayer must make efforts to both secure the required information and substantiate the information, and to the extent it cannot do either, it loses its eligibility for exclusions.

We believe the rules denying eligibility for exclusions are unintended, unneeded and overly punitive. Thus, we respectfully request that they be removed in the final regulations.

Also, because the rules in the proposed regulations are complex and may change before being finalized, it will take taxpayers and the IRS some time to develop information reporting systems to come into compliance. Passthrough entities are also facing new information reporting requirements as a result of other guidance projects related to reporting partner tax capital accounts under Notice 2020-43, Forms K-2 and K-3, section 163(j) business interest deduction limitation, and others. We are hopeful that Treasury and the IRS will extend the effective date for compliance with the regulations to provide Owner Taxpayers and passthrough entities with ample time to build systems to track and report these items.

Conclusion

We appreciate your work on these important regulations and understand the challenge and effort required to provide a comprehensive set of rules for section 1061. We hope that our comments are helpful as you work to finalize these rules. Please do not hesitate to contact us if you have any questions about our suggested changes. Thank you for your thoughtful consideration of our perspectives.

Sincerely,

Bobby Franklin
President and CEO
National Venture Capital Association
Arlington, VA