Earlier this week, Senators Manchin and Schumer reached an agreement securing the former’s support for a tax bill proposed by Senate Democrats entitled the “Inflation Reduction Act of 2022” (the “Act”). Included in the Act are several provisions intended to increase tax revenue, among them a provision designed to raise $14 billion in tax revenue over 10 years by closing the so-called “carried interest loophole.”
The term “carried interest” generally refers to a profits interest in an investment-focused partnership or limited liability company taxed as a partnership for federal income tax purposes (each, an “Investment Pass-Through Entity”) that is held by a manager providing investment management services to such entity for a fee (the “Fund Manager”) (e.g., the general partner of the partnership or the managing member of the limited liability company). Under current federal income tax law, the Fund Manager generally can qualify for long-term capital gains treatment on distributions to it by the Investment Pass-Through Entity if the assets giving rise to such distributions have been held for over three years before being sold. That means taxation at a maximum rate of 23.8%, as opposed to the 37% maximum rate that ordinarily applies to compensation paid for the performance of services. It is this differential treatment in tax rates that proponents of the Act argue creates a “loophole.”
Putting aside whether a “loophole” genuinely exists (the private equity industry certainly would disagree with such assessment and perhaps argue that other policy concerns, e.g., the cost of investment in business, have not been adequately considered by Congress), the Act seeks to expand the holding period to qualify for long-term capital gains treatment to over five years. In addition, the holding period would be calculated in a manner potentially making it more difficult for a Fund Manager to qualify for long-term capital gains treatment.
The Act, if enacted into law, would not end carried interest, but it would make the tax benefits of carried interest more difficult for the Fund Manager to achieve. It is unclear whether the Act will pass, as Senate Republicans appear united in their opposition to it. Senator Kyrsten Sinema has not indicated whether she will vote for it. Senator Sinema previously has noted her opposition to tax increases, including those related to carried interest.