Schumer-Manchin Proposed Inflation Reduction Act of 2022 Would Have Significant Implications for the Taxation of Carried Interest

Schumer-Manchin Proposed Inflation Reduction Act of 2022 Would Have Significant Implications for the Taxation of Carried Interest

On Wednesday, Senate Majority Leader Chuck Schumer and Senator Joe Manchin released proposed legislation called the Inflation Reduction Act of 2022 (the “Act”) that would fund energy and healthcare programs while reducing the deficit through new revenue-raising measures. One such measure is a proposal to limit the beneficial tax treatment of fund managers’ carried interest even further than the limits enacted as part of the Tax Cuts and Jobs Act of 2017 (the “TCJA”). While the prospects for the Act’s passage remain uncertain, the Act is being introduced under the Senate’s reconciliation procedures and its passage requires only the approval of a majority of the Senate. The fact that Senator Manchin has approved the Act strengthens the prospects for the Act’s additional limits on the beneficial tax treatment of carried interests to be enacted in the relatively near future.

Holder-Level Five-Year Holding Period

Significantly, the Act would amend Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”), to provide that all capital gains (or items of income taxed at capital gain rates) of a partner “attributable to” an “applicable partnership interest” (an “API”) will be characterized as short-term capital gain taxable at ordinary income rates if they are recognized within five years after the later of (a) the date on which the partner (i.e., the carried interest holder) acquired “substantially all” of the API, or (b) the partnership acquired “substantially all” of the assets held by the partnership.  Other than certain clarifying modifications, API would have largely the same meaning as in the current Section 1061 of the Code and is intended to include the vast majority of fund managers’ carried interests.

The TCJA originally introduced the current regime for the taxation of carried interest, whereby a holder generally will only be entitled to benefit from long-term capital gain rates with respect to assets held by the relevant partnership for at least three years. The Act, therefore, would significantly extend the timeline for fund managers to receive the beneficial tax rate applicable to long-term capital gain,¹ in part, by focusing not only on a fund partnership’s holding period in its assets, but also on fund managers’ holding periods in their APIs.

This proposal would have many practical implications:

• Five Year or More Timeline. Under the current regime, all carry holders could benefit from long-term capital gain rates in just three years after the fund’s acquisition of an asset disposed of at a gain. However, under the Act’s proposal, fund managers would not receive those benefits until at least five years after the API is issued to them and possibly much longer depending on the timing and amount of capital called for add-on investments, the fund’s structure and the fund’s investment period.²
• Items Taxed at Capital Gain Rates. Under current law, there are certain types of income that are taxed at more favorable long-term capital gain rates, but that are not subject to recharacterization if attributable to carried interest. However, the Act would specify that any income taxed at capital gain rates would be subject to recharacterization as short-term capital gain, including, for example, “qualified dividend income,” and Section 1231 gain.
• Meaning of “Substantially All.” Given the importance of the meaning of “substantially all” to the five-year holding period requirement, much will turn on how this term is defined in regulations. For example, for funds that call capital over a number of years, if “substantially all” requires starting the holding period after a fund partnership has acquired 80% or more of its entire investment assets, the partnership level’s five-year holding period may be tolled and not start for a long period after the fund’s closing. Furthermore, it is not clear how the five-year holding period will be determined in situations where a fund reinvests a substantial amount of the gains recognized on asset dispositions.
• Deferral Ineffective. As a result of the TCJA’s changes to the taxation of carried interest, many fund agreements have adopted a strategy that permits them to defer carried interest until it can be received in a tax-efficient manner. This type of strategy may not be permitted at all under the Act, and if and where it is permitted, would entail greater economic risk to managers whose funds adopt such a strategy.
• Enhanced Conflict of Interest. The TCJA’s change to the taxation of carried interest resulted in potential conflicts of interest between investors and their fund managers given that fund managers are incentivized to hold investments for at least three years when they otherwise might have sought an earlier exit. The changes proposed in the Act would significantly exacerbate this conflict with managers incentivized to hold investments for even longer periods. While most funds hold investments for longer than three years, it is not uncommon for dispositions to occur prior to the end of the five-year or more holding period proposed in the Act. If a buyer is willing to do so, it may be possible to bridge this gap through a rollover of the managers’ share of the underlying investment. 
• Alternative Monetization Strategies. Funds may want to consider alternatives to dispositions, such as leveraged distributions, to determine whether they may provide advantageous tax results compared to the sale of a portfolio company. 
• C Corporation Holdings Potentially Useful. As in the existing Section 1061 of the Code, there is an exception for APIs held directly or indirectly by a C corporation.³ The use of C corporations to hold APIs would result in taxation at both the corporate level and upon distribution to the fund manager, and as a result has generally not been a popular strategy by most funds to mitigate the consequences of Section 1061. However, given that the federal income tax rate applicable to C corporations is currently just 21% versus a top rate of 40.8% for individuals, the ability to benefit from lower initial tax rates at the corporate level in exchange for deferral of the receipt of cash could make a C corporation structure a viable option if the Act is enacted into law in its current form.

Transfers of Carried Interest

Under current law, long-term capital gain that would otherwise be recognized on a transfer of an API is recharacterized as short-term capital gain in certain circumstances upon a transfer to a related person. The Act appears to broaden the recharacterization of a carry holder’s gain on the transfer of an API from long-term capital gain to short-term capital gain to most, if not all, transfers of APIs, and to even recharacterize as taxable a carry holder’s gains realized pursuant to an otherwise non-recognition transaction (such as a Code Section 721 transfer to a partnership or a Section 351 transfer to a corporation), at least in the case of any such transfer that occurs during the five-year holding period.⁴

As a result of the above changes, although the language of the Act is not entirely clear, it appears that gain recognized on transfers of APIs would be subject to the same broad recharacterization rules as gain recognized on transfers of the fund’s underlying assets.

Conclusion

The foregoing discussion describes the statutory language as currently proposed by the Act, which, if enacted, would be effective for tax years beginning after December 31, 2022. The Act may be enacted in an amended version. It may not be enacted at all. In addition, certain provisions of the Act likely will need to be interpreted and refined in Treasury regulations. O’Melveny will monitor further developments with respect to the Act and the tax treatment of carried interest generally. Please contact the attorneys listed on this Client Alert or your O’Melveny counsel for questions regarding the information discussed herein.

¹ The holding period requirement above is reduced from five to three years for API holders with an adjusted gross income of less than $400,000 and for many real estate investment fund managers.  This would offer some relief to affected individuals, but the Act’s definition of holding period would, nevertheless, result in significant, adverse consequences for those individuals as compared to their treatment under current law.

² Investment fund managers should consult with tax advisors as to whether there are alternative structures that may mitigate some of the consequences of the five-year holding period, including by avoiding potential cross-contamination from multiple platform investments using multiple carry vehicles.

³ Although Treasury had clarified this was the case in regulations, the language of the Act makes clear that only APIs held by C corporations are exempt from the recharacterization rules.

⁴ Current regulations permit certain transfers to fund managers’ estate planning vehicles to escape the three-year holding period rules introduced by the TCJA. It is not clear whether the Act would permit the issuance of regulations with similar exceptions.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alexander Anderson, an O’Melveny partner licensed to practice law in New York, Luc Moritz, an O’Melveny partner licensed to practice law in California, and Billy Abbott, an O’Melveny counsel licensed to practice law in California and New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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