August 12, 2022, update: The Inflation Reduction Act passed by the Senate and being reviewed by the House, which is expected to send the bill to President Biden for signature, does not include the modifications to existing Section 1061 discussed in this Legal Update.
On July 27, 2022, US Senators Chuck Schumer and Joe Manchin announced that they reached a deal on a budget reconciliation bill generally intended to combat inflation. While titled the Inflation Reduction Act of 2022 (the “Inflation Reduction Act”), buried in the bill (to the surprise of many) is a revenue raiser fixed on making certain modifications to existing Section 1061, which may significantly change how carried interest is taxed.1 But these modifications are not new. Rather, they mirror the modifications proposed last September as part of the Biden administration's proposed Build Back Better Act.
Section 1061: Background
Congress enacted Section 1061 as part of the 2017 Tax Cuts and Jobs Act to reform the tax treatment of service providers that receive a carried interest in funds or certain other investment vehicles. Where a partnership interest or the underlying partnership asset being sold has been held for three years or less, Section 1061 converts the treatment of the gain from long-term capital gain (taxed at preferential rates) to short-term capital gain (generally taxed at ordinary income rates) with respect to a certain partnership interest (an “applicable partnership interest” or an “API”) if such interest is issued in connection with the performance of services for the partnership.
Some highlights of the Inflation Reduction Act’s proposed changes to Section 1061 are summarized below.
- Holding Period Extended. To preserve the long-term capital gains treatment, the holding period requirement is extended from three to five years, except with respect to APIs attributable to a real property trade or business and for certain taxpayers with modified adjusted gross income below $400,000.
- Substantially All Requirements. The five-year holding period does not begin until the later of when (i) the taxpayer acquires substantially all of the API or (ii) the partnership acquires substantially all of its assets (the “Substantially All Requirements”).
- It is unclear how the Substantially All Requirements will apply as "substantially all" is not defined.
- In addition, in light of the requirement that Section 1061 applies without regard to Section 83(b) election, it is unclear when the Substantially All Requirements will be satisfied if an API is granted subject to vesting.
- Type of Income Expanded. The types of income subject to Section 1061 are expanded to cover qualified dividend income, Section 1231 capital gain and loss (property used in trade or business which is of particular relevance to real estate partnerships and funds), Section 1256 capital gain and loss (contracts marked to market), and other capital gains and losses characterized without regard to the holding period rules, such as REIT capital gains or those under the mixed straddle rules.
- Mandatory Gain Recognition. Gain is recognized in connection with any transfer of an API, including transfers that would otherwise be tax-free under other provisions of the Code (e.g., contributing an API to another partnership). The proposed gain recognition rule applies regardless of whether the API was held for more than five years at the time of the transfer, although the holding period will determine whether the gain is recognized as short-term or long-term gain.
- Anti-Avoidance Regulations Coming. The Treasury Department is authorized to issue anti-avoidance regulations to address partnership agreement provisions that permit carry waivers and in-kind property distributions.
- Corporation Exception Clarified. The API exception for interests held by corporations now specifically applies only to interests held by C corporations, eliminating the possibility of using an S corporation to get around Section 1061 recharacterization.
The proposed amendments would be effective for tax years beginning after December 31, 2022.
The Implications for Investment Advisors
If enacted into law, the Inflation Reduction Act would significantly affect the ability of investment advisors to receive preferential tax rates with respect to their carried interests.
Most importantly, the Substantially All Requirements would introduce a great deal of uncertainty and adversely affect most investment advisors that receive carried interests. For open-ended funds such as hedge funds or other investment vehicles with an indefinite life, investment advisors receiving carried interests may find it difficult to ever satisfy the Substantially All Requirements as it is unclear when such open-ended fund would be considered as having acquired substantially all of its assets. Moreover, even in the case of funds with a finite term, the Substantially All Requirements significantly increase the likelihood that any gain recognized by carry recipients in connection with a disposition of a fund asset would be treated as 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 the investment advisor is able to recognize long-term capital gain in connection with the disposition of the fund’s investments.
The Substantially All Requirements may also make it challenging for investment advisors in a fund of funds to structure carried interests in a way that permits long-term capital gains recognition, notwithstanding that the holding period could be satisfied with respect to each underlying fund. Similar issues may arise for a long-term incentive plan that utilizes a carry partnership covering multiple investment programs.
Furthermore, the Substantially All Requirements, in combination with the increased five-year holding period requirement, could meaningfully increase the economic risk to investment advisors using carry waiver or fee waiver mechanics. As described, for a fund with an investment period of five years, investment advisors that waive their carry or management fees may have to wait more than 10 years to be caught up for such waived amounts in order to receive long-term capital gain treatment.
The Inflation Reduction Act would recharacterize certain types of income that is currently subject to long-term capital gains tax rates to short-term capital gains. For example, the Inflation Reduction Act would expand Section 1061 to cover qualified dividend income (generally taxed at long-term capital gain rates). This expansion may make certain transactions that result in qualified dividend income, such as dividend recapitalization transactions, less attractive. Similarly, real estate advisors recognizing income subject to special treatment under Section 1231 can be adversely affected, as the Inflation Reduction Act may recharacterize such income to short-term capital gains. While those funds engaged in a real property trade or business would be subject to a three- rather than a five-year holding period, the expected benefits of that exception would be limited due to the uncertainty of the Substantially All Requirements. In addition, for investment advisors of real estate debt funds who may receive carried interest as allocations of REIT capital gain distributions, this shorter, three-year holding period would not likely apply as such funds are not engaged in a real property trade or business.
Finally, the mandatory gain recognition provision with respect to any transfer of APIs would eliminate the ability of investment advisors to contribute their carried interests 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 advisors that could be subject to gain recognition in connection with a partnership merger or transaction that would otherwise be tax-free to investors in the fund.
All will be watching closely over the next weeks to see if the Inflation Reduction Act is enacted into law or suffers the same fate as the Build Back Better Act. If enacted, the Inflation Reduction Act will have a significant effect on fund management compensation. Even if the Inflation Reduction Act is not enacted, we may very well see the same or similar provisions in a future bill.
1 Any section reference in this Legal Update is to the Internal Revenue Code of 1986, as amended from time to time.