Senate Majority Leader Chuck Schumer (D-N.Y.) and Senator Joe Manchin (D-W.Va.) have disclosed the preliminary particulars of a bill that will address climate change, taxes, health care, and inflation. The bill is titled the Inflation Reduction Act of 2022.
The carried interest proposal that was initially included in the Build Back Better Act that was presented by the House Ways and Means Committee on September 13, 2021, is reintroduced by this bill in exactly the same form as it was presented in the original version of the bill.
(Please refer to the earlier warning.) It is anticipated that the bill will be brought to the floor of the Senate during the week beginning August 1 for a “vote-a-Rama,” which is a process that would circumvent the typical threshold of 60 votes.
After that, a bill with the same provisions needs to be approved by the House before it can be signed into law by President Biden.
Extended duration of the hold
At the moment, carried interest must be held for at least three years under Section 1061 of the Internal Revenue Code to avoid unfavourable short-term capital gain treatment (generally, a partnership interest held by an investment professional in connection with the performance of services).
This holding period would be extended to five years after the fund acquires “substantially all” of its investments under the proposed rule for investment professionals who have an adjusted gross income of at least $400,000 (or, if later, five years after the investment professional acquires “substantially all” of their carried interest).
For instance, carried interest holders are generally subject to short-term capital gain rates on any gain realized through the end of the eighth year if a fund acquires a substantial majority of its investments by the 31st of December in the third year of operation.
The term “substantially all” is used in both of these contexts, but the bill does not define it. For investment professionals with an “adjusted gross income” below $400,000 (also not defined) and for income that is attributable to a real property trade or business, the 5 years is reduced to 3 years.
Wider Aspects of It
The proposed rule also broadens the application of Section 1061 so that it encompasses all forms of income that, under normal circumstances, would be eligible for the favourable tax treatment accorded to long-term capital gains.
This includes income from qualified dividends, gain from the sale of active business assets (gain from Section 1231), and gain from Section 1256 contracts, among other types of income.
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Transactions Involving the Transfer of Carried Interest
Even if the transferor had held the carried interest for more than three years, under the law as it stands, the conversion of long-term capital gain to short-term capital gain can occur if a carried interest is sold to certain related parties in the context of a taxable transaction.
This conversion is based on a hypothetical sale of the fund’s underlying assets. In its place, the bill would 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.
This related-party rule would be eliminated as a result of the passage of this legislation.
