On July 27, 2022, Senate Majority Leader Chuck Schumer (D-NY) and Senator Joe Manchin (D-WV) announced an agreement on a climate, health and tax reconciliation package dubbed the Inflation Reduction Act of 2022 (IRA). The IRA, if enacted in its current form, would further limit long-term capital gain eligibility for carried interest by, among other things, increasing the required holding period from three to five years. The IRA also proposes changes to the carried interest rules that are identical to changes that were proposed in September 2021 in the House Ways & Means (W&M) Committee reconciliation bill as part of the Build Back Better Act reconciliation legislation (W&M Proposal). This article summarizes certain key changes to the carried interest rules in the IRA which, if enacted in its current form, would increase the tax burden on investment professionals and other taxpayers under certain circumstances.
OVERVIEW OF CARRIED INTEREST RULES
Section 1061 of the Code, enacted in 2017 as part of the Tax Cuts and Jobs Act, recharacterizes certain gain that would otherwise qualify as long-term capital gain with respect to “applicable partnership interests” as short-term capital gain. An applicable partnership interest is any interest in a partnership which, directly or indirectly, is transferred to (or is held by) a taxpayer (a Carried Interest Holder) in connection with the performance of substantial services by that taxpayer, or any other related person, in any applicable trade or business (Carried Interest). Thus, under Section 1061, a three-year holding period generally is required for a holder of a Carried Interest to qualify for long-term capital gains treatment with respect to that interest.
IS THE HOLDING PERIOD REALLY FIVE YEARS?
Like the W&M Proposal, the IRA would extend the current three-year holding period to five years for investment fund managers (and certain other taxpayers) to qualify for long-term capital gain with respect to their Carried Interests. Any other gain would be treated as short-term capital gain (generally taxed at ordinary income rates).
The five-year holding period generally would begin on the later of:
- The date on which the investment professional acquired substantially all of its Carried Interest or
- The date on which the investment fund acquired substantially all of its assets.
Neither the IRA nor the existing statute defines “substantially all.” While previous proposed regulations defined “substantially all” of an investment fund’s assets to mean 80% of such assets (excluding cash and certain other assets), such definition was not adopted in the final regulations. Moreover, under the IRA, a validly made election under Section 83(b) upon receipt of unvested Carried Interest will not cause the applicable Carried Interest Holder to be treated as acquiring substantially all of its Carried Interest. In order to avoid a delay in the five-year holding period beginning under the test set forth above, investment professionals may need to tweak their approach to time and performance vesting in current arrangements.
Treasury Regulations will be needed to provide certainty for investment professionals as they apply the “substantially all” test across an investment portfolio that will undoubtedly include various special purpose vehicles and parallel funds.
Similar rules apply to tiered partnerships where the upper-tier partnership receives Carried Interest in a lower-tier partnership. However, it is unclear the extent to which Carried Interest in a lower-tier partnership that does not meet the foregoing holding period requirements may impact the taxability of gain on Carried Interest in an upper-tier partnership that is not otherwise attributable to such lower-tier Carried Interest.
Notwithstanding the limitations described above, for (1) taxpayers (other than trusts or estates) with adjusted gross income of less than $400,000 or (2) any income that is attributable to a real property trade or business, only a three-year holding period (subject to the same later of determination discussed above) is required.
This is a significant unfavorable change to investment professionals. In addition to the uncertainty of when an investment fund is treated as acquiring “substantially all” of its investments, in practice, given that investment funds typically deploy capital over a multiyear investment period, such funds may not be considered to have invested “substantially all” of their assets for several years, thereby delaying the start of the holding period requirement. This delay could extend the holding period requirement well beyond the headline five-year holding period requirement (and possibly even beyond the ownership of an investment). For example, if a private equity fund is only considered to have acquired “substantially all” of its assets in year four of the fund’s life, the holding period with respect to Carried Interest held by an investment fund manager would only begin in year four and would effectively be extended to nine years.
EXPANDED SCOPE OF CHARACTER RECLASSIFICATION
As was the case with the W&M Proposal, the carried interest provisions in the IRA appear intended to materially expand the scope of the current gain recharacterization rules under Section 1061. The “net applicable partnership gain” of a Carried Interest Holder that is subject to recharacterization (absent the availability of an applicable exception) would not only cover gains and losses realized by such Carried Interest Holder with respect to its Carried Interest directly (e.g., on a sale or exchange of that Carried Interest), but would be expanded to capture other items of income allocable to a Carried Interest Holder from items that—but for special characterization rules—would not otherwise be classified as long-term capital gains. For example, Section 1231 provides that gain recognized upon a sale or exchange of property used in a trade or business is (subject to certain exceptions) treated as long-term capital gains. Such Section 1231 gain is also currently treated as long-term capital gain for purposes of Section 1061. The IRA would revise Section 1061 to negate that long-term capital gain characterization for a Carried Interest Holder’s allocable share of such gain. This would have the effect of eliminating one planning alternative whereby a partnership sells its assets used in a trade or business as opposed to the partners (including a Carried Interest Holder) selling their interests in the partnership. Under the revised rules, the portion of such long-term capital gain allocable to a Carried Interest Holder would, absent an applicable exception, be treated as ordinary income instead. This change would appear to impact several other similar preferential “character” rules in other contexts, including qualified dividend income received by a partnership in which a partner holds Carried Interest.
ALL IN THE FAMILY
Under the existing regime, if a taxpayer transfers Carried Interest (directly or indirectly) to a related person, the taxpayer must include gross income (as short-term capital gain) and the excess of the long-term gain with respect to such Carried Interest that is attributable to the sale or exchange of an asset held for three or fewer years and that is not otherwise treated as short-term capital gain under the carried interest rules with respect to the transfer of the Carried Interest. While the existing regulations clarify that this rule does not result in the acceleration of gain with respect to all transfers of Carried Interest to a related party, the IRA would drastically alter these rules by requiring full gain recognition on any transfer of Carried Interest to a related party. This revised rule would effectively disregard the nonrecognition rules otherwise applicable to transfers of this kind.
For this purpose, a related person includes:
- A member of the taxpayer’s immediate family, including spouse, children, grandchildren and parents.
- A person who performed a service during the calendar year of the transfer or the preceding three calendar years in any applicable trade or business in which, or for which, the taxpayer performed a service.
If enacted, the limitation on transfers to related parties resulting from the IRA is likely to have far-reaching impacts on estate planning considerations for taxpayers holding a Carried Interest.
FAMILY OFFICES STILL WAITING FOR GUIDANCE
The IRA carried interest rules would retain the broad provision that says the Secretary of the Treasury (in regulations) can provide that the recharacterization rules of Section 1061 do not apply to income or gain attributable to any asset not held for portfolio investment on behalf of third-party investors. Since the original Section 1061 rules were adopted in 2017, this has been commonly considered by practitioners as a potential exception for family offices since holders of Carried Interests in such contexts arguably are not overseeing portfolio investments of third-party investors, but rather just family members. To date, no regulations have been issued and the IRA proposal retains the language without any further clarification on its scope or intent.
NEXT UP: WAIVER ARRANGEMENTS?
Some investment funds also utilize carried interest waivers, pursuant to which the Carried Interest Holder may waive its entitlement to gain from the sale of assets that would be classified as short-term capital gain under Section 1061 in exchange for an additional allocation of future gain from the sale of other assets. Another arrangement of investment fund managers that the IRS has been evaluating since 2015 (when proposed regulations were issued) is the use of preferential “fee waivers,” whereby a fund manager may waive its entitlement to management fees (which are generally taxed as ordinary income) in exchange for additional Carried Interest (potentially eligible for preferential long-term capital gains treatment). The 2015 proposed regulations set forth guidelines as to when such arrangements potentially would not be respected yet have not been adopted to date. Along with the other changes to Section 1061, the IRA proposal includes authority for the US Department of the Treasury to develop regulations that “prevent avoidance” of the Section 1061 rules, including through the use of “carry waivers.” It appears that US Congress may be looking to revisit carry waivers and use compliance with Section 1061 to potentially further restrict such arrangements. Any validly waived management fees would appear to continue to qualify as Carried Interest, however, such Carried Interest attributable to waived fees would be subject to the modified Section 1061 rules. We’ll continue to scrutinize the viability and efficiency of waiver arrangements for our clients.
If the IRA is passed as currently proposed, the new carried interest rules discussed above would become effective for tax years beginning after December 31, 2022. Among other planning matters to be considered and reevaluated in the interim, Carried Interest Holders contemplating any estate planning transfers of their Carried Interests, in particular, should consider whether time is now of the essence to do so before year-end.