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.