In a move that surprised most tax professionals and political observers, Senators Schumer and Manchin last week announced an agreement on a new Senate bill, the Inflation Reduction Act (the Act), that is intended to make investments in domestic energy production and manufacturing and reduce carbon emissions. The Act proposes to fund these investments and deficit reductions by raising $739 billion in tax revenues and enacting prescription drug pricing reform.
The tax proposals in the bill are three-fold:
- Modifying Sec. 1061 to further limit the applicability of long-term capital gain rates on carried interests,
- Enacting a 15% corporate alternative minimum tax
- Increasing IRS tax enforcement
The proposed tax provisions would take effect in tax years beginning after Dec. 31, 2022. It is notable that the bill text does not address the state and local tax (SALT) tax deduction cap that was enacted in 2017 with the Tax Cuts and Jobs Act (TCJA) which some Democratic Senators have indicated would be imperative for their support for any tax legislation to pass.
Carried Interest Provisions
The proposed changes to the carried interest rules will be of interest to investment funds. Specifically, the Act is proposing to extend the holding period for applicable partnership interests (API) from three years to five years, with the holding period not deemed to begin until the fund has made “substantially all” of its investments. It is not clear if that definition will follow the previous proposed regulations under Sec. 1061 where a fund would need to invest at least 80% of its assets for the holding period to begin.
In addition, the proposed bill text would expand the application of ordinary income tax rates to all assets otherwise taxed at capital gain rates, such as qualified dividend income, gains on real or depreciable property under Sec. 1231 and gains on derivatives under Sec. 1256.
The proposed bill would further accelerate gain recognition on the transfer of an API despite any nonrecognition provisions that otherwise exist. This would have a significant impact on estate and gift tax planning and could potentially affect pre-sale restructurings of pass-through portfolio company investments.
Exceptions to the extended five-year holding period would apply for real property trade or businesses and to individuals with taxable income of $400,000 or less. They would continue to be subject to a three-year holding period for long-term capital gains rates to apply.
The bill also includes provisions to allow the Treasury to further limit avoidance transactions, such as carry waivers and the distribution of property from partnerships.
Those in affected industries, including private equity and venture capital firms, should review the draft legislation with their advisors to discuss the impact on their fund operations and realizations. Many funds will likely consider accelerating certain realization transactions that may be impacted by these proposed changes if the legislation moves ahead unchanged.
Corporate Alternative Minimum Tax (CAMT)
The bill proposes a 15% corporate alternative minimum tax on applicable corporations, defined as those with average annual adjusted financial statement income (AFSI) of over $1 billion, when measured over a three-year period. The threshold is reduced to $100 million for corporations owned by foreign parents.
Special rules exist for corporations who were in existence for less than three years or had short periods. The calculation of book profits would be tied closely to financial statement income, with certain adjustments, including for income from controlled foreign corporations (CFCs) and disregarded entities (DREs), certain taxes paid, and others. The 15% CAMT would be due to the extent it exceeds the corporate AMT foreign tax credit for the year.
The bill includes aggregation rules to determine which companies meet the threshold test for average annual AFSI which could potentially result in a fund’s portfolio companies being pulled into the computation and result in them being subject to the CAMT.
Increased IRS Enforcement
The bill proposes to increase funding of the Internal Revenue Service to hire auditors, improve customer service, and invest in modernized technology. The bill sponsors’ goal is to thus raise approximately $124 billion in tax revenue by enforcing compliance with existing tax rules.
Outlook
The bill text is headed to the Senate floor. It is unclear if it will garner sufficient support amongst Democratic Senators to pass in its current form. Senator Krysten Sinema has yet to support the bill. In addition, the carried interest provisions of the Build Back Better Act (BBBA), proposed in 2021, were cited by some as reason for opposition to that bill and partially faulted for its demise last year. It is unclear if they will survive in their current form in the Inflation Reduction Act.