Build Back Better Act Tax Proposals: Will Tax Reform Bill Be the Death of Carried Interest?

Carried interest has long been the target of lawmaker scrutiny. While the Stop Wall Street Looting Act, a comprehensive bill first introduced in 2019, never made it out of committee in a Republican-controlled Senate, the current legislative movements in a now Democrat-controlled Senate and House have gained significant momentum.

The proposal approved by the House Ways and Means Committee in September, which is part of a large tax and spending package currently being debated in Congress, aims to change the law to significantly modify the so-called carried interest loophole by limiting situations that are eligible for the more tax favored long term capital gain (“LTCG”) treatment. Some of the highlights of the proposal, its potential impact to Section 1061, and how it treats carried interest are summarized below.

Changes to Holding Periods

The first of these changes is the whole approach to determining what is subject to Section 1061. It no longer is based on the underlying holding period of the asset but rather the holding period in the “applicable partnership interest” (“API”).

It would now start by classifying all capital gains from an API as a short-term capital gain. This would include any item of income taxed at LTCG rates. For instance, Section 1231 gains (gains from the sale of active business assets) which are taxed at LTCG rates, currently are not subject to Section 1061. Under the proposal, the Section 1231 gains would be included as well as qualified dividends and Section 1256 gains and any other gain that would be taxable under the favorable LTCG rates. This would significantly broaden the income subject to Section 1061.

Currently, if property is held for more than three years, the LTCG from the sale of the property is not reclassified to short-term capital gain. Under the proposal, in order to avoid the API classification, the API must be held for more than 5 years. If, however, the API is held by someone with adjusted gross income of less than $400,000 and any income with respect to an API that is attributable to a real property trade or business within the meaning of Section 469(c)(7), there will still be a three-year holding period.

The holding period under the proposal adds rules for measuring the five-year or three-year holding period, including for tiered entities. The holding period is measured from the latest of (i) the date on which the taxpayer acquired substantially all of the applicable partnership interest with respect to which the amount is realized, (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, and (iii) if the partnership in which the taxpayer holds an applicable partnership interest owns, directly or indirectly, interests in one or more other partnerships, the dates determined by applying rules similar to the foregoing in the case of each such other partnership.

This new required holding period would be five years after the fund acquires substantially all of its investments (or if later, after the date when the investment professional acquired substantially all of the carry). A newly admitted partner would not be able to benefit from the long-term holding period of the assets held by the partnership. Given the new holding period requirements, carry waivers would seem to be much harder to accomplish.

The proposal provides no guidance as to the meaning of “substantially all.” This raises the question for PE/VC funds that make multiple investments over time. Depending on the sizes of the investments, the five-year period may not begin to run until the last investment is made. This would mean that the holding period could be significantly longer than five years with respect to investments acquired early in the fund’s investment period (e.g., if the fund acquires substantially all its investments over 3-5 years, the five-year holding period would not start for any investments made by the fund until years the fund has made substantially all its investments between years three and five). In addition, any elections under Section 83(b) are disregarded.  This would mean that the five-year holding period would not start until all vesting requirements are met.

Transfers of Applicable Partnership Interest

The proposal also would rewrite the rules related to transfers of APIs. Currently, the final regulations recharacterize gain on the transfer of an API to a related person limited to transfers in which long-term capital gain is recognized under chapter 1 of the Internal Revenue Code. In contrast, the proposal would provide that if a taxpayer transfers an API, gain shall be recognized notwithstanding any other provision of Subtitle A. The proposal does not define “transfer.” Likely, the provision would apply to all transfers, whether or not the transfer is to a related person and whether or not gain is recognized in the transaction. The rule would impact gifts of APIs, transfers upon death, restructuring transactions to divide carry and management operations in anticipation of a “GP Stakes” transaction (i.e., a partial sale of the sponsor business), and partnership merger transactions when partners in the target partnership hold APIs, among others. Some of these provisions were originally in the proposed regulations but were later removed from the final regulations that were issued. It appears the House wants the IRS to implement these provisions by providing direct statutory language.

The proposal clarifies that an API does not include any interest in a partnership directly or indirectly held by a C corporation; this would codify the position taken in the final regulations that a partnership interest held by an S corporation is not excluded from the term API.

Granting of Regulatory Authority

Finally, the amendment would add specific grants of regulatory authority “to prevent the avoidance of the purposes of Section 1061, including through the distribution of property by a partnership and through carry waivers” as well as to provide for the application of Section 1061 “to financial instruments, contracts or interests in entities other than partnerships to the extent necessary or appropriate to carry out the purposes of Section 1061.”

These changes are effective for taxable years beginning after December 31, 2021. This will apply to all existing funds and current investments. Considering the provisions regarding transfer could override nonrecognition provisions, consideration should be given to accomplish gifting transactions, internal restructurings, and other nonrecognition transactions that could involve the disposition of an API prior to the effective date.

Where Do We Go From Here?

The above discussion focuses only on the provisions from the House Committee on Ways and Means legislation that are intended to be included in the “Build Back Better” Act now being considered by the full House. Once this is passed in the House, then the Senate will take over the process. Both Senators Ron Wyden (D-Oregon) and Elizabeth Warren (D-Mass.) have previously submitted proposals that go farther than the current House proposals in dealing with carried interest and other provisions impacting Private Equity. It remains to be seen whether any of these proposals will make it into a final Senate version or what other modifications the proposal may undergo if it becomes subject to the budget reconciliation process. We will of course keep you informed.