Proposed Senate Bill Would Impact Carried Interests

On July 27, 2022, the Inflation Reduction Act of 2022 (the “Proposed Act”) was introduced in the Senate.  The Proposed Act includes a number of domestic spending provisions aimed at addressing certain longstanding climate and healthcare initiatives.  Among other significant federal income tax proposals intended to offset the new spending and reduce the federal deficit, the Proposed Act would make substantial changes to the federal income tax treatment of “carried interests.”  “Carried interests” refer to partnership profits interests received for the provision of services in any “applicable trade or business.”  The Proposed Act refers to this as an “applicable partnership interest” or “API.”  An “applicable trade or business” includes activities consisting of raising or returning capital and investing in, disposing of or developing specified assets, including securities, commodities and real estate held for investment or development.

The proposed changes discussed below, if enacted, would be effective for tax years beginning after December 31, 2022.  As drafted, there is no grandfather provision for existing partnership interests.

A vote on the Proposed Act is expected as soon as this week, and then it would need to go through the reconciliation process with the House.  Accordingly, even if enacted, the language may change prior to enactment.

Carried Interest Changes:

• As enacted by the Tax Cuts and Jobs Act of 2017, Section 1061 of the Internal Revenue Code, provides that the holder of an API generally may recognize long-term capital gain if the underlying assets generating the gain have been held by the partnership for more than three years. 

• In general, the Proposed Act would expand the required holding period to five years (the “Five-Year Holding Period”), subject to certain exceptions discussed below. 

• The Proposed Act also provides a new rule for measuring the Five-Year Holding Period. Under this rule, the holding period for a taxpayer’s API will be treated as starting on the later of (i) the date on which the taxpayer acquired “substantially all” of the API or (ii) the date on which the partnership in which such API is held acquired “substantially all” of its assets.  There is no definition in the Proposed Act of “substantially all” for these purposes. 

• The Proposed Act significantly broadens the scope of income to which Section 1061 and its holding period requirements apply. Under the proposed revisions, all “net applicable partnership gain” with respect to an API will be treated as short-term capital gain.  “Net applicable partnership gain” is a new term introduced by the Proposed Act.  It covers all amounts included in the gross income of a taxpayer with respect to any API held by the taxpayer, provided that such amounts are treated as capital gain or subject to capital gain tax rates.  Notably, certain widely relied upon exceptions to the three-year holding period rule of existing Section 1061 would no longer be available, such as (i) the exception for long-term capital gain determined under Section 1231, which includes income from the sale of real property used in a trade or business, (ii) the exception for long-term capital gain determined under Section 1256, which includes gain from certain mark-to-market contracts and (iii) the exception for qualified dividend income. 

• Two significant exceptions to the Five-Year Holding Period are included in the Act. The exceptions apply to (i) taxpayers (other than a trust or estate) with an adjusted gross income of less than $400,000 and (ii) income with respect to an API that is “attributable to a real property trade or business.”  In such cases, the Five-Year Holding Period is reduced to three years. 

Under existing Section 1061, many real estate funds have taken the position that the current three-year holding period did not apply as much of the gain generated by such funds was gain attributable to or from the sale of property used in a trade or business or so-called “1231 gain.”  This approach may not be available under the Proposed Act, though gain “attributable to a real property trade or business” would be subject to a three-year holding period rather than the “Five-Year Holding Period.”  

• The scope of transfers of an API to which Section 1061 applies would also be substantially broadened by the Proposed Act. Existing Section 1061, as applied under the Treasury Regulations, treats as short-term certain gain from otherwise taxable transfers to related parties.  Under the Proposed Act, all transfers of APIs would be subject to tax, regardless of the transferee and regardless of whether a nonrecognition provision otherwise would have applied.  

The modified transfer rules seem to apply to routine restructuring transactions where general partners seek to aggregate holders of carried interests or contribute/distribute such interests within the fund structure.  This could both accelerate the timing of income recognition in addition to causing some or all of the income to be treated as short-term capital gain.    

• The Proposed Act also includes certain clarifying modifications to the text of Section 1061. Among these is a clarification that a partnership interest held by an S corporation can be an API. 

• The Proposed Act authorizes regulations to prevent the avoidance of the Proposed Act, including through distributions of property and through carry waivers.

We are continuing to monitor the Proposed Act as it is considered by Congress.  Please reach out to us with any questions about the Proposed Act and its changes to the tax treatment of carried interest.