US Senators Joe Manchin and Chuck Schumer announced on July 27 an agreement in principle on a legislative proposal, known as the Inflation Reduction Act of 2022, that includes a range of measures addressing consumer energy costs and carbon emissions, Medicare’s ability to negotiate drug prices, an extension of benefits under the Affordable Care Act, and federal deficit reduction—as well as significant federal income tax changes.

Among the tax changes in the Inflation Reduction Act of 2022 (the Act) is a proposal to alter the taxation of “carried interest” received by managers of private investment funds. The Act addresses the taxation of “carried interest” through amendments to Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”), which was originally enacted as part of the Tax Cuts and Jobs Act of 2017.

Generally, under current law, managers receiving allocations of “carried interest” from private investment funds may treat those allocations as long-term capital gains, subject to federal income taxation at favorable reduced long-term capital gain rates, if the underlying assets that generate the gains allocated to the managers as part of their “carried interest” are held for more than three years.

The Act would make the following series of changes to the current rules:

• A carried interest holder’s “net applicable partnership gain” would be taxable as short-term capital gain, and thus not eligible for the favorable long-term capital gain rates.
• The carried interest holder’s “net applicable partnership gain” would include allocations of what would otherwise be long-term capital gain in respect of the carried interest, as well as allocations of other income that would be treated as long-term capital gain or subject to tax at long-term capital gain rates. This would include, for example, allocations of “qualified dividend income” received from investments in US corporations that do not meet the holding period requirement.
• The Act would still permit a carried interest holder to obtain long-term capital gain treatment on carried interest allocations under certain circumstances.
  • Specifically, “net applicable partnership gain” (taxable as short-term capital gain), would not include amounts realized after the date that is five years after the later of:
    • the date on which the carried interest holder acquired “substantially all” of the carried interest in respect of which the allocation is made, or
    • the date on which the private investment fund acquired “substantially all” of the assets held by the fund.
  • The standard for what constitutes “substantially all” for purposes of these tests is not specified by the Act and will need to be addressed by the Treasury Department and the Internal Revenue Service (presumably through regulatory guidance).
  • The Act provides that these rules will be applied without regard to Code Section 83 and any Code Section 83(b) election made by a carried interest holder. Thus, a carried interest holder subject to commercial vesting may not be treated as having acquired “substantially all” of that holder’s interest prior to the completion of vesting, even if that holder makes a valid Code Section 83(b) election at the time of a carried interest grant.
  • The five-year time period is reduced to three years in the case of a carried interest holder that has adjusted gross income of less than $400,000 and in the case of carried interest allocations from a private investment fund that are attributable to a real property trade or business.
• The Act provides that, if a holder transfers a carried interest, the holder will recognize gain notwithstanding any other provision of federal income tax law. This broad rule replaces a narrower rule that applies under current law to transfers to related persons. As drafted, it is not entirely clear how any gain recognized under this new provision will be treated under the general rules described above.
• The Act also modifies Code Section 1061 in certain technical respects. In particular, the Act modifies the statutory language of Code Section 1061 to make it clear that these rules will apply to a carried interest held by an “S corporation”.
• The Act grants the Treasury Department broad authority to promulgate regulations to implement these new rules. In particular, the Act authorizes the promulgation of regulations to prevent the avoidance of the purpose of these new rules, “including through the distribution of property by a partnership and through carry waivers.” As many private fund managers have adopted approaches intended to mitigate the impact of the current rules under Code Section 1061, any such regulations will be of significant interest to participants in the private funds industry.

The Act states that the proposed changes to Code Section 1061 will be effective for tax years beginning after December 31, 2022. In light of the new limitations (in particular, the new five-year holding period requirement), it is expected that market participants will seriously evaluate potential sale transactions that may close before the end of 2022.

At this time, it is uncertain if the Act will become law or if the proposed changes to Code Section 1061 will be enacted as they currently appear in the draft of the legislative text released on July 27. Morgan Lewis’s tax practice group and investment funds industry teams will be monitoring this legislation as it progresses and are available to discuss the implications of this legislation for participants in the private funds industry.

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