On July 27, 2022, U.S. Senators Chuck Schumer and Joe Manchin announced that they had reached agreement on a budget reconciliation bill generally intended to fight inflation. Although titled the Cut Inflation Act of 2022 (the “Cut Inflation Act”), buried in the bill (to the surprise of many) is a revenue generator determined to make certain changes to existing Section 1061, which may significantly change how carried interest is taxed.
1 But these changes are not new. Rather, they mirror changes proposed last September as part of the Biden administration’s proposed Build Back Better Act.
Section 1061: Context
Congress enacted Section 1061 as part of the Tax Cuts and Jobs Act of 2017 to reform the tax treatment of service providers who receive interest earned in funds or certain other tax vehicles. investment. Where a partnership interest or the underlying partnership asset sold has been held for three years or less, section 1061 converts the gain treatment to a long-term capital gain (taxed at rates interests) as a short-term capital gain (generally taxed at the ordinary rate of income) in respect of a certain partnership interest (an “Applicable Partnership Interest” or “API”) if such interest is issued in framework of service delivery for the partnership.
Proposed Changes
Some highlights of the Inflation Reduction Act’s proposed changes to Section 1061 are summarized below.
- Prolonged holding period. In order to preserve long-term capital gains treatment, the holding period requirement is increased from three to five years, except for RP attributable to a trade or real estate business and for certain taxpayers whose modified adjusted gross income is less than $400,000.
- Virtually all requirements. The five-year holding period does not begin until (i) the taxpayer acquires substantially all of the IPA or (ii) the partnership acquires substantially all of its assets (the “substantially all requirements assets”) the latest.
- It is unclear how the substantially requirements will apply, as “substantially” is not defined.
- Further, in light of the requirement that Section 1061 apply regardless of the election of Section 83(b), it is unclear when the substantial requirements will be satisfied if a API is granted subject to acquisition.
- Expanded income type. The types of income subject to Section 1061 are expanded to cover qualified dividend income, Section 1231 capital gains and losses (property used in trade or business which is particularly relevant to partnerships and mutual funds). real estate), section 1256 capital gains and losses (mark-to-market contracts), and other capital gains and losses characterized without regard to holding period rules, such as REIT capital gains or those subject to the mixed overlap rules.
- Mandatory recognition of winnings. The gain is recognized in connection with any transfer of RPNs, including transfers that would otherwise be exempt from tax under other provisions of the Code (for example, contributing RPNs to another partnership) . The proposed gain recognition rule applies whether the API has been held for more than five years at the time of transfer, although the holding period determines whether the gain is recognized as a short-term or long-term gain .
- Anti-avoidance rule to come. The Treasury Department is authorized to issue anti-avoidance regulations to deal with provisions of partnership agreements that permit portage waivers and in-kind property distributions.
- Clarified company exception. The API exception for interests held by corporations now specifically applies only to interests held by C corporations, eliminating the ability to use an S corporation to circumvent the Section 1061 recharacterization.
The proposed changes would apply to taxation years beginning after December 31, 2022.
Implications for Investment Advisors
If enacted, the Cut Inflation Act would significantly affect the ability of investment advisers to benefit from preferential tax rates with respect to their carried interest.
More importantly, the near-all requirements would introduce a great deal of uncertainty and hurt most investment advisers who receive carried interest. For open-ended funds such as hedge funds or other indefinite life investment vehicles, investment advisers receiving carried interest may find it difficult to meet the requirements for the most part, as it is not clear when such an open-ended fund would be considered to have acquired substantially all of its assets. Moreover, even in the case of fixed-term funds, the requirements for substantially all assets greatly increase the likelihood that any gain recognized by carry beneficiaries on the disposal of a fund asset will be treated as a short-term capital gain. For example, if a fund has an investment period of five years, the investment advisor may have to wait 10 years before being able to recognize a long-term capital gain on the disposition of the fund’s investments.
Substantially requirements can also make it difficult for a fund-of-funds investment advisers to structure interest-bearing in a way that allows recognition of long-term capital gains, even though the holding period may be satisfied for each underlying fund. Similar issues can arise for a long-term incentive plan that uses a carry partnership spanning multiple investment programs.
In addition, the near-totality requirements, combined with the increased five-year holding period requirement, could significantly increase the economic risk for investment advisers using carry waiver or fee waiver mechanisms. As described, for a fund with an investment period of five years, investment advisers who waive their carry or management fees may have to wait more than 10 years to be made up for those waived amounts in order to benefit from a long-term capital gain treatment.
The Inflation Reduction Act would reclassify certain types of income currently subject to long-term capital gains tax rates as short-term capital gains. For example, the Inflation Reduction Act would extend Section 1061 to cover eligible dividend income (generally taxed at long-term capital gains rates). This expansion may make certain transactions that generate qualified dividend income, such as dividend recapitalization transactions, less attractive. Likewise, real estate advisers recognizing income subject to special treatment under Section 1231 may be affected, as the Inflation Reduction Act may reclassify such income as short-term capital gains. While funds engaged in a real estate trade or business would be subject to a three-year hold period rather than five years, the expected benefits of this exception would be limited due to the uncertainty of the requirements for virtually all goods. In addition, for real estate debt fund investment advisers who may receive deferred interest as allocations of capital gains distributions from REITs, this shorter three-year holding period would likely not apply, as these funds are not engaged in any trade or real estate business.
Finally, the mandatory gain recognition provision in respect of any transfer of API would eliminate the ability of investment advisers to contribute their carried interest to another entity on a tax-free basis as part of an internal restructuring. or for estate planning purposes. This could create conflicts for investment advisers who may be subject to gain recognition in a merger or partnership transaction that would otherwise be exempt from tax for investors in the fund.
Look forward
All will be watching closely over the next few weeks to see if the Cut Inflation Act is enacted or suffers the same fate as the Build Back Better Act. If enacted, the Curbing Inflation Act will have a significant effect on fund manager compensation. Even if the Reducing Inflation Act is not enacted, we could very well see identical or similar provisions in a future bill.
Footnote
1 All section references in this legal update are to the Internal Revenue Code of 1986, as amended from time to time.
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This article by Mayer Brown provides information and commentary on interesting legal issues and developments. The foregoing is not a complete treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action regarding the matters discussed here.
