August 15, 2022

Schumer-Manchin Bill Looks to Tighten Carried Interest Loophole

The recently introduced Inflation Reduction Act of 2022 addresses the taxation of carried interest. A carried interest (“carry,” “incentive,” “promote”) is a form of compensation received by a partner/fund manager in exchange for investment management services. A carried interest entitles a fund manager to future profits of a partnership, also known as a “profits interest.”

Under current law, a fund manager is generally not taxed when a profit’s interest is issued and pays tax only when income is realized by the partnership, often in connection with the sale of an investment occurring years later. Not only does this allow a fund manager to defer paying tax, but the eventual income from the partnership almost always takes the form of capital gains income, which is taxed at a preferential long-term rate of 23.8% compared to the top rate of 40.8% for wage-like income (both rates include the 3.8% net investment income tax).

The Inflation Reduction Act would modify the Code Sec. 1061 carried interest rules. The “Net applicable partnership gain” from the carried interest would be treated as short-term capital gain unless a partner held their interest in a partnership for five years (rather than the current three years). In that case, the gain would be taxed at long-term capital gain rates. Additionally, a partner would only have to hold the gain for only three years to get long-term-gain treatment if the partner had income of less than $400,000 or the gain was attributable to a real property trade or business under the passive activity rules.

These changes would apply to tax years beginning after December 31, 2022.