On July 27, the Senate reached a deal that would raise taxes on carried interest income earned by investment managers.  If enacted, the Inflation Reduction Act of 2022 (the “Act”) would amend the relatively new Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”), which was effective beginning in the 2018 tax year under the Tax Cuts and Jobs Act. Section 1061 was Congress’ attempt to close what many call the “carried interest loophole” that allows investment managers to recognize capital gains rather than ordinary income taxed at higher rates.

Section 1061 currently recharacterizes certain long-term capital gains with respect to carried interests into short-term capital gains, taxed at ordinary tax rates, if the carried interest holder has not satisfied a three-year holding period as opposed to the standard one-year holding period.  The Act would replace the three-year holding period with a five-year holding period but provides two exceptions: (1) a taxpayer other than a trust or an estate with an adjusted gross income of less than $400,000, and (2) income with respect to any carried interest that is attributable to certain types of real estate businesses such as real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, or leasing.  The five-year holding period begins on the latest of the following:

1. The date on which the taxpayer acquired substantially all of the carried interest with respect to which the amount is realized;
2. The date on which the partnership in which such carried interest is held acquired substantially all of the assets held by such partnership;
3. If a partnership owns, directly or indirectly, interests in one or more other partnerships, the dates are determined by applying rules similar to the rules in clauses (i) and (ii) in the case of each such other partnership.

Section 1061 generally applies only to carried interests in connection with businesses that raise capital and either invest in or develop securities, commodities, real estate held for rental or investment, cash or cash equivalents, and options or derivative contracts with respect to any of the foregoing.  The Act would not expand upon these categories.

Under current rules as confirmed by finalized Treasury Regulations, nontaxable transfers of carried interests subject to Section 1061 to related parties such as family members are permitted without accelerating taxable gain, but future gains may be subject to recharacterization as short-term capital gain. See Treas. Regs. 1.1061-5. However, it appears the Act would significantly change this by requiring gains to be recognized when any carried interest subject to Section 1061 is transferred. It is unclear whether Treasury will interpret the Act to mean that gains are accelerated when a carried interest subject to 1061 is transferred, even in nontaxable transfers such as gift transfers or tax-deferred contributions. If the Act becomes law, Treasury would need to revisit its regulations that were only just finalized at the beginning of 2021.

In addition to amending the carried interest rules, the Act would impose a 15% corporate minimum tax for large corporations (i.e., generally C corporations with more than $1 billion in income as reflected on financial statements), utilize tax credits to incentivize energy and climate investments, and provide the IRS with additional funding to increase tax enforcement.

The Senate plans to complete its work on the Act during the first week of August 2022. If passed, the new amendments would apply to tax years beginning after Dec. 31, 2022.