On July 27, 2022, Senate Majority Leader Chuck Schumer and Senator Joe Manchin reached a deal on new legislation entitled the “Inflation Reduction Act of 2022” to be added to the fiscal year 2022 budget reconciliation bill. President Biden issued a statement of support shortly after its announcement. The significant tax changes to the treatment of carried interest introduced in this bill track the mark-up of the “Build Back Better” Act that came out of the House Committee on Ways and Means last September 2021. Although the current 725 page bill will need to work its way through budget reconciliation and could change meaningfully at any point in the process, this post will highlight some of the key tax takeaways for private fund sponsors based on the bill as currently drafted.

First, the current three year holding period required to achieve long-term capital gain treatment for carried interest payable in connection with a disposition of a fund investment would be replaced with at least a five year holding period requirement (subject to certain limited exceptions, including a notable exception for certain real estate sponsors that allows for a three year holding period for long-term capital gain treatment). Such five year holding period would begin on the later of (i) the date that a sponsor/carry participant acquired “substantially all” of its partnership interest, and (ii) the date that the fund acquired “substantially all” of its assets. As “substantially all” is currently undefined under the legislation, this could raise significant issues for private funds making investments on an opportunistic basis over time.

Second, all capital gains in respect of private fund sponsor carry that do not meet the holding period requirements described above would be classified as short-term capital gains. This expansion of short-term capital gain treatment includes income (such as qualified dividend income) that, under existing rules, would be taxed at preferable long-term capital gains rates irrespective of the holding period in any asset.

Third, a transfer of an appreciated carry participant’s partnership interest (including, by means of a typical tax deferred transfer to a partnership or corporation) would cause the transferor to recognize built in gain in such partnership interest on the date of transfer. Estate planning and “GP-led” secondary transactions are often effectuated through tax deferred transfers of sponsor carried interest and would be impacted by this new rule.

Lastly, the Treasury is explicitly authorized to issue regulations or other guidance “to prevent the avoidance of the purposes of Section 1061, including through the distribution of property by a partnership and through carry waivers.” Such mechanisms are commonly included by private fund sponsors in their fund agreements and used from time to time. 

Senators Manchin and Schumer indicated that the legislation will be submitted to the Senate for review next week. Weil will continue to monitor the progress of this legislation closely and will be considering how to address the potential impact of these rules for our private fund clients. Please let us know if you would like to discuss any aspect of this proposed legislation and how it may impact your specific circumstances and private fund arrangements.