On July 27, 2022, Senate Majority Leader Chuck Schumer and Senator Joe Manchin announced their agreement on proposed legislation (the “Inflation Reduction Act of 2022” or “Act”) that is expected to be considered by the Senate this week. If enacted in its current form, the Act would significantly and adversely impact the tax treatment of “carried interest” held by fund managers. The carried interest changes are proposed to be effective for taxable years beginning after December 31, 2022.

Overview of Current Rule and Changes

Section 1061 of the Internal Revenue Code (the “Code”), enacted in 2017, treats capital gains from an applicable partnership interest (an “API”) as short-term capital gain unless the asset sold was held for at least three years. An API generally is a partnership interest that is received by a taxpayer in connection with the taxpayer’s performance of services in an applicable trade or business (including most investment funds). For private fund managers, this generally includes the manager’s or general partner’s profits interest or carried interest (including a profits or carried interest acquired through a fee waiver mechanism).

Under the Act, the three year holding period would be extended to a minimum of five years (and in many typical cases would be considerably longer), the types of gains that are treated as short-term capital gains under Section 1061 would be expanded and all transfers of APIs (including transfers to unrelated parties) would result in gain recognition to the transferor potentially at short-term capital gain rates.

Expanded Gain Recharacterization

As revised by the Act, Section 1061 would treat an API holder’s “net applicable partnership gain” as short-term capital gain unless an exception applies. “Net applicable partnership gain” is the sum of (A) the taxpayer’s net long-term capital gain determined by taking into account gains and losses with respect to one or more APIs and (B) other amounts that are includible in the taxpayer’s gross income with respect to one or more such APIs and that are treated as capital gains or subject to tax at the rate applicable to capital gains. Currently, Section 1061 does not reach certain income items, such as qualified dividend income and Section 1231 gains, that are taxed at favorable long-term capital gain rates but technically do not constitute long-term capital gains.

The Act’s exception to short-term capital gain treatment is a new holding period rule which extends the holding period requirement from three years to a minimum of five years. Under this exception, net applicable partnership gain will exclude amounts realized on the date that is five years after the later of (i) the date the taxpayer acquired “substantially all” of the API with respect to which the amount is realized, (ii) the date the partnership in which such API is held acquired “substantially all” of the assets held by such partnership, or (iii) in the case of a tiered partnership, the date on which the lower-tier partnership in which the API is held acquired “substantially all” of its assets. The Act does not define what constitutes “substantially all” for purposes of this exception and if enacted will require additional regulatory guidance. In a typical investment fund, this will generally mean that the five year time period will not start until the end of the investor commitment period or the end of the investment period, whichever occurs later. Follow-on investment funding, recycling of investment proceeds and evergreen investment programs could further complicate application of the new holding period requirement for many investment funds.

The Act further states that this rule will be applied without regard to Section 83 of the Code and any election made thereunder. This suggests that an API holder whose interest is subject to vesting may not be treated as having acquired substantially all of its interest until after the vesting period (or substantially all of the period) is complete, regardless of whether the API holder made a Section 83(b) election. Similarly, fund managers that utilize a fee waiver and cashless contribution mechanism to fund their carried interest may not be treated as having acquired substantially all of their interest until all (or substantially all) of the requisite management fees have been waived and applied.

This holding period exception is shortened from five years to three years in the case of (i) an API held by a taxpayer (other than a trust or estate) with adjusted gross income of less than $400,000 and (ii) income with respect to an API that is attributable to certain real property trades or businesses. Again, however, this three year holding period will not start until the later of the date the taxpayer acquired substantially all of its API and the partnership acquired substantially all of its assets. Despite this shortened holding period rule, the Act could have a significant impact on real estate funds and businesses given that Section 1231 gains would be subject to recharacterization as short-term capital gains during the applicable holding period (whereas currently such gains are treated as long-term capital gains after one year).

Expanded Gain Recognition

The Act also would significantly expand the application of Section 1061 by apparently requiring gain to be recognized on any transfer of an API. Currently, Section 1061 merely has the potential to recharacterize (as short-term) gain on the transfer of an API to a related person in a transaction in which gain otherwise would be required to be recognized under other Code provisions. If enacted as proposed, the Act apparently would render taxable, among other API transfers, many common estate planning transfers as well as contributions to corporations or partnerships that currently could qualify for nonrecognition treatment under the Code. As drafted, this gain recognition rule does not appear limited to transfers occurring within the five year holding period (although presumably that holding period would remain relevant to determining whether any gain triggered by the transfer was eligible for long-term capital gain rates).

Anti-Abuse Rules

To address the three year holding period in Section 1061 as currently in effect, private fund managers have typically added two potential “savings provisions” to their fund documents. The first provision permits the fund manager to receive its entitlement to carried interest through a distribution in-kind of portfolio assets, as opposed to proceeds from the sale of those portfolio assets, and the second permits the fund manager to waive its allocation and distribution of carried interest, and to recoup such waived amounts through allocations and distributions of future gains derived by the partnership. The goal of the savings clauses is to defer recognition of gain that would not qualify as long-term capital gain under the three year holding period until the partnership realizes gain that would meet the holding period for long-term capital gain treatment.

The Act would amend Section 1061 to expressly direct Treasury to issue regulations or other guidance to prevent the avoidance of Section 1061, including through the distribution of property by a partnership and through carry waivers, and to provide for the application of Section 1061 to financial interests that attempt to circumvent API classification.

Conclusion

It is difficult to predict whether the proposed changes described above will be enacted or what changes may be made prior to enactment. While Senator Manchin’s agreement to the proposals certainly increases the likelihood of enactment, comparable provisions were dropped from legislation in 2021, ostensibly due to objections from Senator Kyrsten Sinema. Moreover, even if enacted, the full impact of the Act might not be clear until certain aspects are addressed by Treasury guidance. We will continue to track developments in this area closely and assess the practical implications for our clients.