August 4 update: Negotiations in the Senate resulted in this proposal being removed from the bill.
Executive summary: Proposed carried interest modifications
Changes to the tax treatment of carried interest are proposed in the new, rebranded budget reconciliation legislation that Democratic senators publicized on July 27. The proposal, which would affect many private equity firms, hedge funds, the real estate industry and others, replaces the recently added three-year holding period with a differently calculated five-year requirement, and expands the scope of the rule. In addition, any transfer of a carried interest, even one otherwise nontaxable, would result in gain recognition. The proposal is subject to change—or even outright removal—during congressional negotiations as part of the budget reconciliation process.
New calculation and longer holding period
The U.S. Department of the Treasury in its Green Books in fiscal years 22 and 23 included a proposal to tax as ordinary income a partner’s share of income on an “investment services partnership interest,” or ISPI, in an investment partnership, regardless of the character of the income at the partnership level, if the partner’s taxable income from all sources exceeds $400,000.
The proposal was modified in 2021 by the House Ways and Means Committee in its proposed Build Back Better package by replacing the three-year holding period with a differently calculated five-year requirement. Although subsequent iterations of the Build Back Better Act dropped the provision in its entirety, the deal reached on July 27 by Sen. Joe Manchin of West Virginia and Senate Majority Leader Chuck Schumer resurrected the carried interest provision and would adopt the five-year approach from the House Ways and Means Committee proposal.
Notably, the proposal states the five-year period cannot begin before a fund has acquired substantially all of its assets, a date which may never arise for many open-ended investment funds. In addition, any transfer of a carried interest, even one otherwise nontaxable, would result in gain recognition. The effective date for these changes would be for taxable years beginning after Dec. 31, 2022.
For funds engaged in real property trades or businesses according to the section 469 definition, the required holding period will be three years. However, all other rules, including the revised start date, would still apply.
Below are answers to some common questions being asked in response to the proposal.
Q: What is the main proposed change?
Instead of a three-year holding period, there would be a five-year holding period to obtain capital gains rates, for partners whose gains are derived from a carried interest in private equity funds, hedge funds, and similar investments . As before, such interests are referred to as “applicable partnership interests.”
Also, the scope of the rule would expand to include anything taxed similarly to long-term capital gains, including section 1231 gains, section 1256 gains and qualified dividends.
For certain real estate ventures (defined as a real estate trade or business)—many of which were not subject to these rules because the assets generating gain are section 1231 gains—a three-year holding period would apply instead of the current law’s one-year holding period.
For example, gains on a partnership’s sale of improved or unimproved real property used in the partnership’s trade or business of owning office buildings and leasing office space would be subject to a three-year holding period. Currently, such gains on section 1231 property are not subject to the restrictions imposed by the 2017 Tax Cuts and Jobs Act.
Q: What other proposed changes stand out?
The computation of the five-year (or three-year) holding period is different, more complex, still somewhat uncertain, and potentially subject to change as this proposal is scrutinized.
The proposed law takes an entirely different approach from current law, which generally looks at the holding period of the asset being sold (either a partnership’s asset, or the applicable partnership interest itself), and sometimes looks through to the holding period of the partnership’s assets on the sale of the applicable partnership interest.
Instead, the basic rule in all cases is that the partner’s interest in the partnership (the applicable partnership interest) must have been held for five years, with several important caveats:
- The holding period does not commence until the partnership has acquired substantially all of its assets. Presumably, that means substantially all of the assets it is holding when the sale, at issue, occurs. This is a change from current law, which focused only on the holding period of the asset being sold.
- The holding period also does not commence until the partner has acquired substantially all of their interests in the partnership. Presumably, that means their interests in the partnership as of the time that the sale, at issue, occurs.
- Both of these rules are not entirely clear and might change as the provision is clarified or redrafted.
- When all of these rules are taken into account, some funds may conclude that they may never be able to satisfy the applicable holding period.
Q: What is the effective date of the proposed changes?
As proposed, the new rules would apply to “tax years beginning after Dec. 31, 2022.” That would mean there is no grandfather rule for assets acquired before then. This could change, including by regulation, but it appears as though it would apply only to gains reportable on an individual’s Form 1040 for 2023 or any later year.
Various tighteners, like rules against transfers of carried interests, appear also to apply only to “transfers” or other “events” after Dec. 31, 2022. But anyone considering year-end tax planning should consult with their tax advisor.
Q: What other tighteners are included?
A rule imposing income tax upon a gift of a carried interest (or any other transfers that are currently income-tax-free) is added. This applies to all transfers, not just transfers to related parties.
It also appears to apply to a transfer from an individual hedge fund manager’s general partner account to their limited partner account, since that technically involves a transfer that would be taxable, but for a special rule in section 731.
The character of any gain on such a transfer would apparently be determined by applying the general holding period rules as modified by this proposal.
Q: Is this likely to pass, be loosened, be tightened or fall by the wayside?
This is, of course, uncertain, as has been reported in mainstream news outlets.
Keep two things in mind:
- The $14 billion revenue estimate for these changes is very substantial.
- This appears to be the only provision in the Inflation Reduction Act that increases taxes on high-income individuals, something some lawmakers may consider to be a political victory in the current environment of economic hardship for many others.
Q: Can you provide some illustrative examples?
Please consider these examples showing the effect of the proposed law on, first, a private equity fund and its portfolio companies, and second, a fund holding and operating real estate.
Ex: A private equity fund and its portfolio companies
As of Dec. 1, 2022, ABC Fund (a partnership and a private equity fund) has held equity interests in portfolio companies K for six months, X for two years, Y for three years, and Z for five years. The companies may be C corporations or partnerships. It has been six months since the end of the fund’s investment period (for investments in portfolio companies), and it is not anticipated that any substantial new investments will be acquired. Managing partner, M, has been managing the fund and holding their carried interest, which is an “applicable partnership interest,” for five years, as of Dec. 1, 2022.
a. For sales before Dec. 31, 2022 (current law treatment)
i. M can enjoy long-term capital gains on their share of any gains realized by ABC on its sale, on or before Dec. 31, 2022, of Y or Z, but not X (since the current law rules of section 1061 would preclude that) and not K (because the general, one-year long-term holding period has not been met).
ii. The same result would apply even if M had only held their interest in ABC for two weeks.
b. For sales after Dec. 31, 2022 (under the proposed bill)
i. With respect to M’s share of any long-term gains realized by ABC, on any asset, long-term capital gains treatment will be available only for sales after June 1, 2027. This is because of our understanding that the 5-year holding period commences only after the later of the date that ABC has acquired substantially all of its assets, or the date that M has acquired substantially all of their interest in ABC.
ii. With respect to any long-term gains on the sale of M’s interest in ABC, M can enjoy long-term capital gains only for a sale after June 1, 2027. This is because of our understanding that the five-year holding period commences only after the later of the date that ABC has acquired substantially all of its assets, or the date that M has acquired substantially all of their interest in ABC.
Note: As to the commencement of the five-year holding period, it is not clear what will be required to determine whether five years (or three years where applicable as in the next example) have expired since ‘‘(i) The date on which the taxpayer acquired substantially all of the applicable partnership interest with respect to which the amount is realized. . . [and] . . . (ii) The date on which the partnership in which such applicable partnership interest is held acquired substantially all of the assets held by such partnership.”
Ex: A fund holding and operating real estate
The facts are the same, except that K, X, Y, and Z are interests in leased apartment buildings acquired and operated by ABC as a trade or business. In addition, K has been held for one-and-a-half years as of Dec. 31, 2022.
a. For sales before Dec. 31, 2022 (current law treatment)
i. M can enjoy long-term capital gains on their share of any gains realized by ABC on its sale, on or before Dec. 31, 2022, of K, X, Y, or Z. The current law rules impose no special holding period (other than the Section 1231 holding period of one year and one day) on section 1231 property (i.e., depreciable property and real estate used in a trade or business).
ii. The same result would apply even if M had only held their interest in ABC for two weeks.
b. For sales after Dec. 31, 2022 (under the proposed bill)
i. With respect to M’s share of any long-term gains realized by ABC, on any asset, long-term capital gains treatment will be available only for sales after June 1, 2025. This is because of our understanding that a 3-year holding period applies, but that it commences only after the later of the date that ABC has acquired substantially all of its assets, or the date that M has acquired substantially all of their interest in ABC.
ii. With respect to any long-term gains on the sale of M’s interest in ABC, M can enjoy long-term capital gains only for a sale after June 1, 2025. This is because of our understanding that a 3-year holding period applies (because of the nature of ABC’s activities), but that it commences only after the later of the date that ABC has acquired substantially all of its assets, or the date that M has acquired substantially all of their interest in ABC.
The takeaway
While the proposed rules in this bill would have a severe impact on many investment funds, they are still just proposals. As the legislative process continues to evolve, consult with your tax advisor to assess the potential impact of this bill, as well as changes that may be made as the bill progresses toward possible enactment.
Register now for RSM’s Private Client Forum on Tuesday, Aug. 16, which figures to be a timely educational session as the legislative process continues toward the Sept. 30 deadline for passing a budget reconciliation bill.
