Carried Interest Changes in the Inflation Reduction Act of 2022

On July 27, 2022, U.S. Senate Majority Leader Chuck Schumer, D-N.Y., and Sen. Joe Manchin, D-W.Va., announced an agreement to add the Inflation Reduction Act of 2022 to the FY2022 budget reconciliation bill and vote in the Senate next week. The proposed legislation would, among other things, significantly expand the scope of Section 1061,¹ which deals with the taxation of carried interests and other partnership interests issued in connection with the performance of certain services. The modifications in the proposed legislation are the same as the modifications that were proposed as part of the Build Back Better Act (H.R. 5376, 117th Congress).

Lengthening of holding period required to obtain long-term capital gain treatment

Under current law, the holder of a partnership interest subject to Section 1061 may still recognize long-term capital gain on the disposition of certain assets that have been held for at least three years. The proposed legislation would impose a five-year holding period requirement beginning only on the later of the date the taxpayer acquired substantially all of the partnership interest subject to Section 1061 or the date on which the partnership acquired substantially all of its assets (the “Substantially All Requirement”). Because the Substantially All Requirement likely will not be satisfied (if it is satisfied at all) until after a partner acquires an interest in the partnership or the partnership acquires certain of its assets, the applicable holding period for long-term capital gains will be more than five years in most circumstances to which Section 1061 applies.

The practical effect of the Substantially All Requirement may be that investment advisors to hedge funds and similar vehicles that do not have a defined investment period will be prevented from recognizing long-term capital gains with respect to partnership interests that are subject to Section 1061, and investment advisors to private equity and other similar funds will be eligible for long-term capital gains rates only if investments are held for at least five years after the close of the fund’s investment period. For example, a private equity fund that acquires investments in the first year of a three-year investment period may need to hold the investment for at least eight years (the fund’s three-year investment period plus the five-year holding period that commences only after the investment period has closed) for gain on the disposition of the investment to be treated as long-term capital gain to carried interest participants.

Under the proposed legislation, a three-year holding period is substituted for the five-year holding period described above in certain circumstances, including for individual taxpayers with adjusted gross income of less than $400,000 and income attributable to certain real property trades or businesses.

Expansion to cover all income taxed at long-term capital gains rates

Under current law, certain types of income subject to tax at long-term capital gains rates are excluded from the scope of Section 1061, including amounts treated as long-term capital gain with respect to regulated futures contracts marked to market under Section 1256, long-term capital gain under Section 1231, and qualified dividend income from domestic and certain foreign corporations. The proposed legislation would expand the scope of Section 1061 to apply to all items of income that are subject to tax at rates applicable to capital gains.

Denial of long-term capital gain on enterprise value

Investment advisors commonly grant profits interests in the investment advisor’s parent entity. Such profits interests may entitle service providers to share in the overall enterprise value of the business (including the value of the goodwill of the business). These profits interests are within the scope of Section 1061. But the investment advisor’s parent entity is unlikely to be able to satisfy the Substantially All Requirement because there is no fixed period over which that entity will acquire and hold assets. Absent an exception, the effect of this rule would be to convert all gain, including gain attributable to enterprise value, to short-term capital gain.

The proposed legislation contemplates a potential exception for “income or gain attributable to any asset not held for portfolio investment on behalf of third party investors.” But this exception is not self-implementing and requires the Treasury Department to issue favorable guidance.

Recognition of gain on transfers of partnership interests

The proposed legislation would require the recognition of gain in connection with any transfer of a partnership interest subject to Section 1061, regardless of whether the transfer would otherwise be eligible for nonrecognition treatment. This change could have a significant effect on, among other things, mergers and acquisitions of investment advisors and estate planning transactions.

Antiavoidance regulations; carry waivers

An investment fund’s partnership agreement will sometimes contain provisions permitting investment advisors to waive carried interest allocations and distributions in one year in exchange for a priority allocation and distribution in a later year. Such provisions, known as “carry waivers,” may be implemented with a view toward maximizing the amount of long-term capital gain allocated to participants in the carried interest. Investment advisors may also take other actions to delay the recognition of gain on investments that have not been held for the period required by Section 1061, such as making in-kind distributions to the carried interest holder. The proposed legislation would direct the Treasury Department to issue regulations and other guidance to prevent the avoidance of the purposes of Section 1061 through, among other things, in-kind distributions and carry waivers.

Effective Date

The amendments described herein, if enacted, will apply to taxable years beginning after December 31, 2022. Thus, gains recognized on or before December 31, 2022, that were otherwise eligible for long-term capital gain treatment should not be adversely affected by the proposed modifications to Section 1061.