September 27, 2022

Volume XII, Number 270

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September 27, 2022

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September 26, 2022

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Carried Interest Changes in the Inflation Reduction Act of 2022

On July 27, 2022, Senate Majority Leader Chuck Schumer (D-N.Y.) and Senator Joe Manchin (D-W.Va.) released preliminary details of a bill, named the Inflation Reduction Act of 2022, to address climate change, taxes, health care and inflation. The bill reintroduces a carried interest proposal unchanged from what was originally included in the Build Back Better Act introduced by the House Ways and Means Committee on September 13, 2021. (See our prior alert.) The bill is expected to go to the Senate floor the week of August 1 for a “vote-a-rama,” a process that would bypass the usual 60-vote threshold. The House must then pass a similar bill before President Biden signs it into law.

Increased Holding Period

Currently, Section 1061 of the Internal Revenue Code imposes a 3-year holding period to avoid unfavorable short-term capital gain treatment on carried interest (generally, a partnership interest held by an investment professional in connection with the performance of services). For investment professionals with adjusted gross income of at least $400,000, the proposed rule extends this holding period to 5 years after the fund acquires “substantially all” of its investments (or, if later, 5 years after the investment professional acquires “substantially all” of its carried interest). For example, if a fund acquires substantially all of its investments by December 31 of year 3, carried interest holders generally would be subject to short-term capital gain rates on any gain realized through the end of year 8. The bill does not define “substantially all” for either of these purposes. The 5-year period is reduced to 3 years for investment professionals with “adjusted gross income” below $400,000 (also not defined) and for income that is attributable to a real property trade or business.

Expanded Scope

The proposed rule also expands the scope of Section 1061 to include all income that otherwise would be eligible for long-term capital gain treatment, such as qualified dividend income, gain from the sale of active business assets (Section 1231 gain), and gain from Section 1256 contracts.

Transfers of Carried Interest

Under current law, the transfer of a carried interest to certain related persons in a taxable transaction can result in the conversion of long-term capital gain to short-term capital gain, based on a hypothetical sale of the fund’s underlying assets, even if the transferor held the carried interest for more than three years. The bill would eliminate this related-party rule and instead require the recognition of gain in connection with any transfer of a carried interest, regardless of whether the transfer would otherwise be eligible for non-recognition treatment.

Elimination of Planning Techniques

The bill directs the Treasury Department to issue regulations to prevent the avoidance of short-term capital gain treatment under Section 1061 and specifically mentions two techniques commonly used by fund managers: in-kind distributions and carried interest waivers.

Effective Date

The changes would apply to tax years beginning after December 31, 2022.

© 2022 Foley & Lardner LLPNational Law Review, Volume XII, Number 210
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About this Author

Raj Tanden, Foley, development companies lawyer, closely held businesses attorney
Partner

Raj Tanden is a partner and business lawyer with Foley & Lardner LLP, where he represents clients in corporate and tax matters across a broad spectrum of domestic and cross-border transactions. Mr. Tanden chairs the firm’s Southern California Tax Practice. His practice includes assisting clients with investment management transactions, including the formation of and investments by public and private investment funds and investors. Mr. Tanden advises business development companies, closely held businesses, public and private investment funds and real estate investment...

213-972-4575
Christopher T. Bird D.C. Business Lawyer Foley & Lardner
Associate

Christopher Bird is an associate and Business Law attorney with Foley & Lardner LLP. Christopher is based in the Washington D.C. office where he is a member of the firm’s Tax, Benefits, and Estate Planning Practice Group.

...
202-295-4005
Sonia K. Kothari Finance Lawyer Foley and Lardner
Senior Counsel

Sonia K. Kothari is a senior counsel with Foley & Lardner LLP. Sonia is based in the firm’s Washington, D.C. office where she is a member of the firm’s Taxation Practice. Sonia is admitted only in New York. She is practicing under the supervision of a member of the D.C. Bar. 

Sonia focuses her practice on advising U.S. and non-U.S. fund managers on U.S. federal income tax issues relating to the formation and operation of private funds. She also advises on the U.S. federal income tax consequences of mergers and acquisitions, capital market transactions, financings and...

202-295-4087
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