On July 27, 2022, Senator Joe Manchin III (D-W.Va.) and Majority Leader Charles E. Schumer (D-N.Y.) introduced legislation entitled the “Inflation Reduction Act of 2022” (the “Reconciliation Bill”). The Reconciliation Bill is designed to fund climate programs and enhance enforcement by the Internal Revenue Service (the “IRS”), while reducing the deficit. The primary revenue raising provisions would impose a corporate minimum tax (at a rate of 15 percent on adjusted financial statement income), allow Medicare to negotiate prescription drug prices and expand the scope of existing provisions that tax carried interest at ordinary income rates. The carried interest provisions included in the Reconciliation Bill are summarized below.

Background and Current Law

Alternative fund managers commonly receive a performance-based return, in addition to a management fee, for services provided to a managed fund. For funds that are treated as partnerships for U.S. federal income tax purposes, the performance-based return generally is structured as a profits interest in the partnership. This profits interest commonly is referred to as carried interest (which, as used herein, refers to both carried interest typically associated with private equity funds and performance allocations associated with hedge funds).

Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”), addresses the taxation of carried interest. Because carried interest is subject to the same risk of loss as a partnership interest received by a third-party investor in exchange for a capital contribution, the net profits allocated to a fund manager in respect of its carried interest are treated as a distributive share of partnership profits. Accordingly, except as otherwise provided by Section 1061 of the Code, the character of the profits earned by the partnership generally flows through to the fund manager in the same manner as for other holders of partnership interests. Section 1061 of the Code currently extends the general long-term capital gain holding period from more than one (>1) year to more than three (>3) years in the case of gains derived from carried interests. Section 1061 does not alter the taxation of income that is taxable at long-term capital gain rates irrespective of holding period (for example, qualified dividends, certain mark-to-market gains from Section 1256 contracts, and Section 1231 gains (relating to certain depreciable and real property used in a trade or business).

Proposed Changes

The Reconciliation Bill would expand the scope of Section 1061 of the Code by treating net long-term capital gain, as well as any other amounts includible in gross income in respect of a carried interest and treated as capital gain or taxable at capital gain rates, as short-term capital gain and therefore taxable at ordinary income rates. Exclusions from such treatment would be limited to amounts realized after the date that is five (5) years after the latest of:

(i) The date the carried interest recipient acquired substantially all of the carried interest partnership interest (the “applicable partnership interest”) with respect to which the amount is realized;

(ii) The date on which the partnership in which the applicable interest is held acquired substantially all of the assets held by the partnership; and

(iii) If a partnership described in clause (i) above owns, directly or indirectly, interests in one or more other partnerships, dates determined by applying rules similar to those described in clauses (i) and (ii) above to each such other partnership.

The five (5) year period described above would be shortened to exclude amounts realized after a date that is three (3) years after the latest of the dates described in clauses (i) through (iii) above in the case of (A) a carry recipient (other than a trust or estate) having an adjusted gross income of less than $400,000 and (B) income with respect to carried interests attributable to certain real property-related trade or business activity.

Observations: The amendments proposed by the Reconciliation Bill would go beyond simply extending the current long-term capital gain holding period from more than three (>3) years to more than five (>5) years in the case of carry recipients. The term “substantially all” as used above is not defined, but the effect of this definition would be to deny long-term capital gain treatment to income derived from assets acquired earlier on in the investment period, even if held for more than five (>5) years. It is unclear how the look-through rule for tiered partnerships described in clause (iii) above would apply in practice. The amendments also would apply ordinary income rates to additional categories of carried interest income that currently are taxable at long-term capital gain rates irrespective of holding period (for example, qualified dividends, Section 1256 gains and Section 1231 gains, as noted above).

If enacted in its current form, the Reconciliation Bill would amend other aspects of Section 1061 of the Code. These changes would include:

• Recognition of gain on any transfer of a carried interest (as opposed to the more limited requirement under current law that gain be recognized on transfers of carried interests only if made to certain related persons);
• Clarification that holding a carried interest through an S corporation is not an effective work-around; and
• Expansion of regulatory authority to (i) prevent avoidance of Section 1061 of the Code (including through distributions of partnership property and carry waivers) and (ii) expand its application to financial instruments, contracts, and interests in entities other than partnerships (presumably including interests in passive foreign investment companies (or “PFICs”)).

Effective Date

The amendments to Section 1061 of the Code would apply to taxable years beginning after December 31, 2022.

Observation: In large part, the carried interest provisions included in the Reconciliation Bill mirror earlier legislation introduced by the House Ways and Means Committee in September of 2021 as part of the larger “Build Back Better Act” tax and spending package that failed to secure the votes needed to pass in the Senate. While not a positive development for investment fund managers, the amendments contained in the Reconciliation Bill, if enacted, would be less punishing that several earlier legislative proposals. The Reconciliation Bill would amend existing law to broaden the categories of income that are treated as short-term capital gain by carried interest recipients. There is no indication that such income would be treated as compensation for any purpose or subject to self-employment taxes. By contrast, the “Ending the Carried Interest Loophole Act,” introduced by U.S. Senate Finance Committee Chair Ron Wyden (D-Ore.) and Senator Sheldon Whitehouse (D-R.I.) on August 5, 2021, would have taxed carried interest recipients on deemed compensation income irrespective of any actual economic benefit received by a carried interest recipient.