On July 27, 2022, Senator Majority Leader Charles Schumer (D-NY) and Senator Joe Manchin (D-WV) announced that they reached an agreement on proposed legislation, known as the Inflation Reduction Act of 2022. The proposed legislation would, among other things, significantly broaden the application of the carried interest income rules under IRC Section 1061.

The IRC Section 1061 amendments would apply to tax years beginning after December 31, 2022 (see Tax Alert 2021-1681 for a discussion of prior legislative proposals to amend IRC Section 1061).

Background

IRC Section 1061, enacted in 2017 as part of the Tax Cuts and Jobs Act, applies to capital gains income with respect to certain partnership interests known as "applicable partnership interests" (APIs). Generally, APIs are partnership interests acquired or held by taxpayers in connection with the performance of services by those taxpayers or related persons in an "applicable trade or business." At a very high level, applicable trades or businesses include asset management businesses engaged in managing certain types of assets (known as "specified assets") if the businesses also raise or return capital. "Specified assets" include, among other things, shares of corporate stock, debt instruments, commodities, real estate held for rental or investment, publicly traded partnership interests and non-publicly traded partnership interests to the extent that the partnerships own other specified assets.

Generally, IRC Section 1061 operates by recharacterizing long-term capital gain with respect to an API as short-term capital gain to the extent that the holding period of the capital asset generating the long-term capital gain was more than one year but not more than three years. IRC Section 1061 does not apply to income that is not from the sale or exchange of a capital asset but is taxed at long-term capital gains rates under specific Code sections, such as IRC Section 1231 income or qualified dividend income. Treasury regulations promulgated in 2021 clarified that IRC Section 1061(d), which applies to recharacterize long-term capital gain as short-term capital gain for certain related-party transfers of APIs, operates only as a gain recharacterization provision, not as an independent gain-triggering provision.

Analysis of the proposed legislation

The Inflation Reduction Act of 2022 would retain the existing concepts of "applicable partnership interest" and "applicable trade or business" but would make several very significant changes to IRC Section 1061.

Increased holding period

The proposed legislation would increase the three-year holding period to five years. In particular, IRC Section 1061 would no longer operate by recharacterizing long-term capital gains as short-term capital gains to the extent that the asset generating the capital gain had a holding period of more than one year but not more than three years. Instead, IRC Section 1061 would generally recharacterize a taxpayer's "net applicable partnership gain" with respect to an API as short-term capital gain.

Net applicable partnership gain would generally include net long-term capital gains with respect to a taxpayer's APIs, including income items that are treated as capital gains or otherwise taxed at capital gains rates (such as qualified dividend income and IRC Section 1231 income). Net applicable partnership gain would not include any amount that is realized five years or more after the latest of (i) the date on which the taxpayer acquired substantially all of the API with respect to the amount realized, (ii) the date on which the partnership in which the API is held acquired substantially all of the assets held by the partnership, and (iii) the dates determined by applying rules similar to the rules in clauses (i) and (ii) for each other partnership if the partnership directly or indirectly owns interests in one or more other partnerships. The five-year period would decrease to three years for (i) an individual taxpayer with adjusted gross income of less than $400,000 and (ii) any income with respect to an API that is attributable to a real property trade or business as defined in IRC Section 469(c)(7)(C).

Recognize all gain

The bill would modify IRC Section 1061(d) to result in the recognition of all gain from any transfer of an API, even if the transaction would otherwise be entitled to nonrecognition treatment.

Other provisions

The bill would also make several other changes, including:

• Clarifying that the exception to API treatment for a profits interest under IRC Section 1061(c)(1) may apply as long as the taxpayer is performing services in a business other than an applicable trade or business
• Limiting the corporate exception in IRC Section 1061(c)(4)(A) by replacing the term "corporation" with "C corporation"
• Broadening the definition of "specified asset" to include an interest in a non-publicly traded partnership if the partnership owns (directly or indirectly) any specified assets, except as otherwise provided by Treasury
• Explicitly authorizing Treasury to issue regulations or other guidance to (i) prevent the avoidance of IRC Section 1061, including through the distribution of property by a partnership and through carry waivers and (ii) apply IRC Section 1061 to financial instruments, contracts or interests in entities other than partnerships

Takeaways for the fund industry

The proposed changes to IRC Section 1061 would significantly expand its scope in several different ways. The proposed extension of the three-year period in IRC Section 1061 to five years would greatly increase the provision's reach. Similarly, including items that are treated as capital gains or otherwise taxed at capital gains rates, including IRC Section 1231 gains and qualified dividend income, would greatly expand IRC Section 1061's scope. For real property trades or businesses, however, applying a special three-year holding period requirement, as opposed to the five-year holding period requirement that would apply to other activities, would mitigate the impact of that expansion somewhat.

Requiring taxpayers to satisfy the holding period test at multiple different levels (including at the level of each tier in a tiered partnership structure) could significantly increase the total gain subject to IRC Section 1061, as well as complicate taxpayers' efforts to comply with the provision. Replacing the existing, relatively straightforward holding period test, which generally looks to the holding period of the asset generating the capital gain in question, with a test that looks to when "substantially all" of a taxpayer's interests in a partnership and the partnership's assets were acquired would likely to lead to counterintuitive results in many cases. For example, the sale of a capital asset held for only two years would apparently generate long-term capital gain if substantially all the interests in a partnership and substantially all the partnership's assets were acquired more than five years ago. By contrast, the sale of an asset with a seven-year holding period would apparently generate short-term capital gain if (1) the partnership bought a capital asset in Year 1 and sold it in Year 7 and (2) the partnership had a large infusion of capital in Year 3 such that the partnership did not hold substantially all of its assets for five years as of Year 7. In addition, modifying IRC Section 1061(d) to trigger gain on any transfer of an API, even if a nonrecognition provision would otherwise apply, would significantly complicate — or even render completely impractical — many commonplace estate-planning transfers, some third-party investment transactions, and many internal restructurings.

The proposed language specifically authorizing Treasury to issue guidance regarding carry waivers may increase the likelihood that the Treasury will issue such guidance.

Finally, this proposed legislation did not change or modify the so-called capital interest exception to API treatment in IRC Section 1061(c)(4). The grant of regulatory authority to Treasury, however, may increase the likelihood of Treasury imposing further limits upon the capital interest exception.

———————————————