What would the Inflation Reduction Act mean for carried interest taxation?

Update: As of Aug. 5, the carried interest provisions in the proposed Inflation Reduction Act have been removed as a result of the ongoing negotiations. We continue to monitor the progress of the bill and will share updates on significant tax implications. Subscribe now to make sure you receive future insights.

If enacted as currently proposed, the recently announced Inflation Reduction Act would result in significant changes to the taxation of carried interest. Senate Democrats estimate that the proposed changes, which would be effective for tax years beginning after Dec. 31, 2022, would raise $14 billion in tax revenue over 10 years. Some of the significant proposed changes are as follows.

• The legislation would replace the current three-year holding period requirement for fund managers to achieve long-term capital gain treatment on carried interest with a five-year holding period requirement. Additionally, the five-year holding period requirement would not begin until the holder of the carried interest acquires such interest, or until the date the fund acquires “substantially all” of its assets, whichever is later. The proposed legislation does not define “substantially all,” but this requirement could push the required holding period significantly beyond five years, making it very difficult for fund managers to achieve long-term capital gain treatment on any carried interest. 
  
  • The current three-year holding period would continue to apply for taxpayers with an adjusted gross income (AGI) below $400,000 and to carried interest that is attributable to a real property trade or business.
• The Act would significantly expand the scope of IRC Section 1061 by pulling in gains determined under sections 1231 and 1256 and qualified dividend income, all of which are not subject to recharacterization under current law.
• The proposed legislation would require the recognition of gain on the transfers of carried interests regardless of whether the transfer would otherwise be eligible for non-recognition treatment. This would impact common estate planning techniques, such as gifting carried interest to trusts or family members. 
• The legislation authorizes Treasury to issue regulations to prevent the avoidance of recharacterization of carried interest through the distribution of property by a partnership or through carried interest waivers.

The likelihood of ultimate passage of this legislation, and this provision within it, is unclear given the narrow majority the Democrats have in Congress, among other factors. We will continue to monitor its status.

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