On July 27, 2022, West Virginia Senator Joe Manchin and Senate Majority Leader Chuck Schumer introduced the Inflation Reduction Act of 2022, a budget reconciliation bill related to energy spending and tax policy. If enacted, it would negatively impact “carried interest” and add a 15 percent corporate alternative minimum tax for certain corporations. Private equity funds and their sponsors should be familiar with the bill and follow it closely as it makes its way through the legislative process.
Although investments made by private equity funds are typically longer in term, the proposed legislation would exacerbate the inherent misalignment of interests between fund sponsors and their investors and make long-term capital gain treatment unobtainable for many fund sponsors. Specifically:
- Under current law, carried interest is taxable to private equity fund sponsors as short-term capital gain (likely taxable at ordinary income tax rates) unless the investment fund holds the underlying property for more than three years. The bill proposes to increase the requisite holding period from greater than three years to greater than five years. Notably, the current three-year holding period would generally continue for taxpayers that (i) earn less than $400,000 of adjusted gross income or (ii) hold their partnership interest in a partnership that is engaged in a real property trade or business.
- The bill proposes, in part, starting the five-year holding period on the later of (i) the date on which the taxpayer acquires substantially all of its carried interest; (ii) the date on which the partnership that issued the carried interest acquires substantially all of its assets; or (iii) for tiered partnerships, the dates determined by applying rules similar to the rules of (i) and (ii) for each such applicable tier. Current regulations promulgated under Section 1061 provide that it is the holding period of the asset (either an asset of the underlying partnership or the carried interest itself) disposed of that determines the three-year holding period calculation. As drafted, the bill’s language substantially diverges from Section 1061’s current holding period principles and throws into doubt the notion that it is the holding period of the asset disposed of that controls for purposes of Section 1061. Such a change to current law would likely have a substantial effect on current asset disposal techniques that are pertinent to nearly all private equity fund sponsors.
- The bill proposes, in part, to remove the real estate exemption from the three-year holding period requirement set forth in the current final regulations under Section 1061. Under the final regulations, carried interest attributable to real estate held for more than one year in connection with a trade or business is exempt from the three-year holding period as a Section 1231 gain. The bill, however, closes the real estate exemption by requiring a three-year holding period for income with respect to any carried interest attributable to a real property trade or business (instead of the proposed five-year holding period for carried interest attributable to assets other than real estate).
- Under current law, related party dispositions of carried interest is not a gain acceleration event. Without additional commentary, the proposal implies that any transfer of a carried interest to a related party (including transfers via gift and to related entities via nonrecognition transactions) would trigger the recognition of gain.
- The bill proposes that the Department of Treasury issue regulations and other guidance to prevent the avoidance of Section 1061 through in-kind distributions by a partnership and through “carry waivers.” If enacted, the bill and subsequent regulations could end a common practice for private equity fund sponsors to (i) directly hold in-kind distributed partnership property for the balance of the three-year holding period and (ii) seek gain deferral through “carry waivers” notwithstanding the presence of significant entrepreneurial risk with respect to such deferral.
- The bill’s carried interest changes would be effective for tax years beginning after December 31, 2022.
Corporate Alternative Minimum Tax
Corporations are currently subject to a flat tax rate of 21 percent on their taxable income. Due to their low tax rates, corporations have become, in some instances, a favored vehicle for a handful of private equity firms as the structure may prove to be more tax advantageous than investing through a pass-through entity. In addition, the added benefit of not having to provide investors with Schedule K-1s has made corporations a viable alternative to pass-through entity investment depending on the investment structure and investor base. Although unlikely to affect smaller private equity firms, the bill introduces a 15 percent corporate alternative minimum tax to corporations with income on average (based on the current tax year and the prior two tax years) of greater than $1 billion for financial accounting purposes as opposed to tax purposes (this would be modified for certain corporations that are owned by foreign parent corporations). The minimum tax would to be effective for tax years after December 31, 2022.
The bill has not been met kindly by the private equity industry and many are anxiously awaiting Arizona Senator Kyrsten Sinema’s comments as she has previously expressed a reluctance to increase corporate or personal tax rates. As it stands, the bill could pose some of the most significant changes to the private equity industry since the enactment of the Tax Cuts and Jobs Act of 2017.