The Inflation Reduction Act of 2022 (IRA) was signed into law by President Biden on Aug. 16, 2022. It has been championed by the administration and Congress as the most sweeping climate and energy reform in history, although it’s a far cry from the various tax proposals that have been made over the past few years.
The IRA provides for two major tax changes — a 15-percent corporate alternative minimum tax (AMT) and a 1-percent surtax on the repurchase of corporate stock. More importantly, the IRA allocates approximately $80 billion in funding to the IRS. However, any change to the taxation of carried interest is notably missing from the final version of the law.
Corporate Minimum Tax
The IRA imposes a new AMT on corporations (other than S corporations, regulated investment companies and real estate investment trusts) equal to 15 percent of their “adjusted financial statement income” (AFSI) if AFSI exceeds an average of $1 billion annually over a three-year period (i.e., the tax-year at issue and the prior two tax-years).
AFSI is defined under IRC § 56A as “the net income or loss of the taxpayer set forth on the taxpayer’s applicable financial statement for such taxable year, adjusted as provided in this section.” In general, an applicable financial statement is one that is prepared in accordance with generally accepted accounting principles and meets the requirements of IRC § 451(b)(3).
The corporate AMT is effective for tax years beginning after Dec. 31, 2022.
Stock Repurchase Surtax
The IRA imposes a 1-percent surtax on the fair market value of any stock in a publicly traded domestic corporation that is “repurchased” by such corporation through a redemption or economically similar transaction (see IRC § 4501). Of course, there are exceptions. The IRA does not impose the surtax where the repurchase is:
- Part of a tax-free reorganization
- Contributed to an employer-sponsored retirement plan or employee stock ownership plan
- For less than $1 million (in the aggregate of all repurchases during the tax-year)
- Made by a dealer in securities in the ordinary course of business
- Made by a regulated investment company or real estate investment trust
- Treated as a dividend
Like the corporate AMT, the new law applies to stock repurchases occurring after Dec. 31, 2022.
IRS Funding
It is no secret that the IRS has consistently struggled to perform. There are widespread reports of unanswered phone calls, millions of unprocessed paper returns, archaic technology and a workforce decimated by the COVID-19 pandemic. The IRA’s distribution of approximately $80 billion in funding to the IRS over the next 10 years is expected to address these issues, increase productivity and capture foregone revenue. The IRA allocates the funds as follows:
- $3.18 billion for taxpayer services
- $45.63 billion for enforcement
- $25.32 billion for operations support
- $4.75 billion for business system modernization
- $15 million for development of a new e-file system
- $403 million for general administration
- $104 million for tax policy
- $153 million for Tax Court
- $50 million for Treasury office expenses
The Carried Interest Saga
The most interesting and controversial proposed tax change was eliminated from the bill at the eleventh hour to secure Senator Kyrsten Sinema’s vote — taxation of carried interest.
Pooled investment vehicles like private equity (PE) funds are typically structured as a partnership made up of one general partner (the PE firm that manages the fund) and numerous limited partners (“silent” individual investors). The general partner raises capital to purchase a portfolio of several private companies with the intention of selling those interests for a profit by the end of the fund’s term.
While the individual members of the PE firm may invest directly in the portfolio companies through “co-investment” vehicles, the PE firm itself generally makes little to no capital investment as the general partner. It is compensated with a management fee and a profits interest in the fund’s performance. This profits interest is known as “carried interest” or simply “carry.” While not used in every case, the “2 and 20” model is commonly used to structure these fees — a 2-percent management fee and a 20-percent carry in excess of any hurdle. The remaining profits are distributed to all the investing partners, pro rata, subject to any adjustments in the distribution waterfall.
When the fund sells a portfolio company, it generates a capital gain. Because the interest in the portfolio company would likely be held for more than three years before sale, the gain that flows through to the general partner and out to the members of the PE fund as carry qualifies for long-term capital gain (LTCG) treatment. Thus, carried interest is taxed at a much lower rate than ordinary income or short-term capital gain (STCG).
This tax treatment has received much opposition over the years by those who would like to see carry taxed at the higher ordinary income rates. Some headway was made by the opposition in 2017 when the Tax Cuts and Jobs Act enacted IRC § 1061, which governs the way carried interest is currently taxed. Sec. 1061 increased the required holding period for LTCG treatment of carried interest from one year to three years. In practice, however, it minimally affects carried interest for PE funds because portfolio companies are likely to be held by the fund for more than three years.
The proposed changes that did not make it into the IRA would have amended Sec. 1061 by affording LTCG treatment at the individual partner level to gain which is realized more than five years after the later of (1) the date on which the individual partner (the taxpayer) acquired substantially all of its interest in the general partner of the fund and (2) the date on which the fund acquired substantially all of its assets. This five-year rule would have instituted a significant hurdle for PE firms to receive LTCG treatment of carried interest, but for now, taxation of carried interest remains unchanged.