On June 27, US Senators Joe Manchin and Chuck Schumer announced proposed legislation referred to as the Inflation Reduction Act of 2022 (the Act).  The proposed legislation includes changes that would expand the scope of IRC section 1061, which generally imposes limits on tax benefits available to carried interests and other compensatory partnership interest arrangements.

By way of background, carried interest arrangements have long been used by private investment funds, including private equity, real estate, hedge funds and other alternative asset management funds, as a way to compensate and incentivize fund managers.  The carried interest typically is issued to the fund manager as a non-taxable equity interest in the fund that entitles the fund manager to share in future profits of the fund.  The issuing fund is classified as partnership (a pass-through entity) for tax purposes, and the pass-through treatment of the fund allows the fund manager’s share of fund capital gains to be taxed to the fund manager as long-term capital gain that is eligible for preferential capital gains rates, notwithstanding that the fund manager is issued the carried interest as consideration for services.

In general, under section 1061, which was enacted as part of the 2017 Tax Cuts and Jobs Act and is effective for taxable years beginning after 2017, capital gains with respect to an applicable partnership interest (API) must satisfy a three-year (rather than one-year) holding period requirement in order to qualify for long-term capital gain treatment. More specifically, section 1061 treats as short-term capital gain (taxable at ordinary income tax rates) the amount of net long-term capital gain with respect to an API that exceeds the amount of such gain calculated as if a three-year holding period applies.  For purposes of section 1061, an API generally is defined as an interest in a partnership that is transferred to or held by a taxpayer in connection with the performance of substantial services by the taxpayer (or a related person) in an applicable trade or business, which generally includes any trade or business activities which consist of raising or returning capital and either investing in or disposing of specified assets or developing specified assets, such as securities, commodities, or real estate held for investment or rental. 

The Act generally would modify section 1061 as follows:

• The Act generally would increase the three-year holding period to 5 years, with certain exceptions, and such holding period would begin at the later of (i) the date on which the taxpayer acquires substantially all of the API and (ii) the date on which the partnership acquired substantially all of the assets held by such partnership. Further, these rules may apply to tiered partnership arrangements.

• An exception to the five-year holding period rule (substituting three years for five years) would apply in the case of (i) a taxpayer (other than a trust or estate) with adjusted gross income of less than $400,000 and (ii) any income with respect to the API is attributable to a real property trade or business within the meaning of IRC section 469(c)(7)(C).

• Currently, section 1061 does not apply to certain items treated as capital gain or subject to tax at capital gains rates with respect to an API, such as gains determined under IRC sections 1231 and 1256, qualified dividend income described in IRC section 1(h)(11)(B), and other capital gain that is characterized as long-term or short-term without regard to the holding period rules under IRC section 1222, such as gain characterized as capital gain under the identified mix straddle rules of IRC section 1092(b). The Act would effectively cause these items, and any other items treated as capital gain or subject to tax at capital gains rates, to be subject to section 1061 and the holding period rules described above.
• Currently, section 1061 excludes from the definition of API any interest in a partnership directly or indirectly held by a corporation.  The Act would exclude only such interests held by a “C” corporation. 
• The Act would cause gain to be recognized on the transfer of an API, regardless of any nonrecognition provision of the IRC. 
• The Act would broaden the authority of the Secretary to issue regulations to prevent avoidance of section 1061, including through the distribution of partnership property or through carry waiver arrangements (under which a fund manager may waive a right to a share in partnership income or gain items that would be treated as short-term under section 1061), and to address the application of the provisions to financial instruments, contracts or interests in entities other than partnerships.