Taxpayers should be aware that they may soon lose the advantage of long-term capital gain treatment in respect of carried interest should the Inflation Reduction Act of 2022 (2022 IRA) become law. The deal on a reconciliation package announced on July 27 by Senators Chuck Schumer (D-N.Y.) and Joe Manchin (D-W.Va.) would raise an estimated $739 billion in revenue, of which an estimated $14 billion would come from closing tax-advantaged provisions for carried interests.
The 2022 IRA legislative text on carried interests is identical to the 2021 proposal contained in the House-passed Build Back Better bill (H.R. 5376). That proposal was stricken from the House bill in Nov. 2021 because of opposition from Senator Kyrsten Sinema (D-Ariz.).
The carried interest provisions, if now adopted, are proposed to be effective for taxable years beginning after December 31, 2022.
Present law
The Tax Cuts and Jobs Act added Section 1061 to the Internal Revenue Code effective for taxable years beginning after December 31, 2017. Section 1061 generally requires that a capital asset be held for more than three years for capital gain allocated with respect to any applicable partnership interest (API) to be treated as a long-term capital gain. Section 1061 recharacterizes the long-term capital gain of an API holder as short-term capital gain where the typical one-year holding period requirement has been met, but the disposed property has not been held for more than three years.
An API is generally any interest in a partnership that, directly or indirectly, is transferred to (or held by) the taxpayer in connection with the performance of services in any applicable trade or business. The services may be performed by the taxpayer or by any other related person or persons in any applicable trade or business. An applicable partnership interest does not include a capital interest in a partnership giving the taxpayer a right to share in partnership capital commensurate with the amount of capital contributed (as of the time the partnership interest was received) or commensurate with the value of the partnership interest that is taxed under Section 83 upon the receipt or vesting of the partnership interest.
An applicable trade or business means any activity (regardless of whether the activity is conducted in one or more entities) that consists in whole or in part of the following: (1) raising or returning capital, and either (2) investing in (or disposing of) specified assets (or identifying specified assets for investing or disposition), or (3) developing specified assets. Specified assets mean securities (generally as defined under rules for mark-to-market accounting for securities dealers), commodities (as defined under rules for mark-to-market accounting for commodities dealers), real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to such securities, as well as an interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing. Reporting requirements and regulatory authority are provided under the provision.
2022 IRA proposed changes to carried interest taxation
Under the 2022 IRA, if one or more applicable partnership interests are held by a taxpayer at any time during a taxable year, the taxpayer’s net applicable partnership gain for the taxable year is treated as a short-term capital gain. Net applicable partnership gain means net long-term capital gain determined by only taking into account the taxpayer’s gains and losses with respect to applicable partnership interests and any other amounts includable in gross income with respect to an applicable partnership interest that are treated as capital gain or are subject to tax at the rate applicable to capital gain. The proposal thus expands the types of gain that are treated as short-term capital gain under Section 1061.
Machen McChesney Insight
- Under current regulations for Section 1061, Section 1231 gains are not subject to recharacterization as a short-term capital gain. The 2022 IRA would override those regulations, and Section 1231 gains from APIs would be included in recharacterizations as well as qualified dividends and Section 1256 gains. The inclusion of Section 1231 gains would presumably have a significant impact on carried interests for real estate funds.
Net applicable partnership gain generally does not include amounts realized after a five-year holding period, with certain exceptions. The holding period is three years for any taxpayer (other than a trust or estate) with adjusted gross income (AGI) as determined under the provision of less than $400,000 for the taxable year. The holding period is three years for any income with respect to any applicable partnership interest that is attributable to a real property trade or business. For this purpose, a real property trade or business is defined as in Section 469(c)(7)(C) as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Machen McChesney Insight
- The reduced holding period carve-out for individuals holding APIs with AGI under $400,000 is consistent with the Biden administration’s promise not to increase taxes for individuals with income below that amount. Whether this is meaningful for many individuals who hold carried interests is yet to be seen. The additional carve-out for real property trades or businesses may be helpful to those API holders.
The proposal adds rules for measuring the five-year or three-year holding period, including for tiered entities. The holding period is measured from the latest of specified dates. The dates are:
- the date on which the taxpayer acquired substantially all the applicable partnership interest with respect to which the amount is realized.
- the date on which the partnership (in which such applicable partnership interest is held) acquired substantially all of the assets held by such partnership.
- if the partnership in which the taxpayer holds an applicable partnership interest owns, directly or indirectly, interests in one or more other partnerships, the dates determined by applying rules similar to the foregoing in the case of each such other partnership.
The Treasury Secretary is directed to provide guidance in determining the amount of gain that is treated as short-term capital gain under these rules, as well as guidance as to any necessary and appropriate reporting to enable administration and carry out the purposes of the provision.
Machen McChesney Insight
- Current regulations allow for the measurement of the holding period referencing the actual asset that is being disposed of in a transaction (i.e., the partnership interest’s holding period or the partnership asset’s holding period). The 2022 IRA requires the holding period reference a “latest of” testing date, removing this optionality from planning. Even if substantially all a partnership’s assets were held for more than five years, a newly admitted partner would not benefit from the long-term holding period of the assets, potentially subjecting them to capital gain income recharacterization.
The proposal provides that the present-law rule with respect to certain services that are not taken into account in determining whether an interest is an applicable partnership interest applies to services with respect to a trade or business that is not an applicable trade or business. Additionally, the legislation would codify rules under which Section 83(b) elections, which can accelerate the vesting and holding periods of partnership interest, shall be ignored for the purpose of applying Section 1061.
Machen McChesney Insight
- For purposes of determining holding periods of APIs, Section 83(b) elections are disregarded under the 2022 IRA. Accordingly, the holding period would not begin until all vesting requirements are met. Consideration is therefore warranted with respect to the issuance of typical profits interests in fund structures to the extent such profits interests are subject to vesting requirements.
The proposal modifies the definition of a specified asset, providing that a partnership interest is itself treated as a specified asset (except as otherwise provided by the Secretary) if the partnership has a direct or indirect interest in an asset that is a specified asset (that is, securities, commodities, real estate held for rental or investment, cash or cash equivalents, and options or derivative contracts with respect to any of the foregoing). Regulatory guidance may, for example, define a de minimis direct or indirect interest of a partnership in an asset that is not taken into account for this purpose.
The proposal gives regulatory authority to provide that statutory exclusions from the definition of an applicable partnership interest do not apply, for example, when the application of an exception would not carry out the purposes of Section 1061. The proposal also clarifies that the exception for ownership by a corporation of an interest that would otherwise be an applicable partnership interest applies only to C corporations.
Machen McChesney Insight
- The 2022 IRA would codify the IRS position that APIs held by S corporations are not excepted from the carried interest income recharacterization rules, which was previously only addressed in regulations. Further, this provision along with many others of the 2022 IRA grant broad regulatory authority to the Treasury to prescribe rules for addressing carried interests. Such authority may be broad enough to not require repeated congressional intervention to address the landscape of changes in the investment partnership industry.
The proposal modifies the rule relating to transfers of applicable partnership interests to provide that transfer of an applicable partnership interest requires recognition of gain notwithstanding any other federal income tax rules.
Machen McChesney Insight
- Under current law, transfers to related parties, including colleagues of the transferor, are subject to income recharacterization, but only if the transfer results in long-term capital gain recognition under federal income tax principles. Under the 2022 IRA, gain will be recognized notwithstanding any other federal tax rules. This has implications for estate planning including gifts, transfers upon death, and restructuring transactions.
The proposal requires the issuance of Treasury guidance to prevent the avoidance of the purposes of the proposal through the distribution of property by a partnership or through a carry waiver (e.g., the waiver of gain subject to this provision in return for a future allocation of income, gain or property). The guidance also must apply the rules of Section 1061 in the case of financial instruments, contracts or interests in entities other than partnerships to the extent necessary or appropriate to carry out the purposes of the provision.
Machen McChesney Insight
- Many fund managers use carry waivers to avoid application of the carried interest rules. The Treasury Department and IRS are likely to create additional disclosure requirements intended to ensure that any carry waivers appropriately satisfy existing regulations.
Next steps
There are still at least three key hurdles that need to be overcome for the 2022 IRA and its carried interest provisions to become law:
- the Senate Parliamentarian needs to review and approve the provisions for the reconciliation process.
- Senator Sinema must agree to the carried interest provisions, which are identical to the ones previously stricken from Build Back Better due, in part, to her concerns.
- the House will need to pass the bill in the face of potential opposition from several Democratic members who have previously stated that they will not support a bill that does not include state-and-local tax (SALT) cap relief.
Nonetheless, the agreement between Senators Manchin and Schumer marks a significant step toward the possibility of carried interest taxation changes – which have been floated for years – finally being enacted.
With the carried interest changes proposed to take effect for tax years beginning in 2023, investment funds, fund managers, and other affected taxpayers should begin planning now for the implications of the changes if adopted.
For more information about the above article or other taxation services, contact Michael D. Machen, CPA, CVA, by calling (334) 887-7022 or leaving us a message below.
