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Summer Break?

After the last couple of weeks, I’m looking forward to Congress’s summer vacation. I’m pretty sure our elected representatives feel the same way, though it is unclear at this point when they will be heading to their respective homes – or wherever else it is they go[i] – to relax, recreate, and rejuvenate.

According to the Congressional Calendar, the Senate is scheduled to begin its break on August 6 and to return on September 6, while the House was supposed to have stopped work on July 30 and will be back in session on September 13.[ii]

First Things First

However, certain events during the second half of July seemingly have “conspired” to delay whatever vacations these folks may have planned.[iii]

First, the June 2022 inflation report reflected an annual inflation rate of 9.1 percent (an increase of 1.3 percent from the May figures).

Second, the Federal Reserve raised its benchmark interest rates by 75 basis points (following a similar increase in July).

Third, the Commerce Department announced that the U.S. economy has now experienced two consecutive quarters of negative growth – a rule of thumb definition for a recession.

Fourth, Senator Manchin told Democratic leaders yet again that he wouldn’t support tax increases, which seemed to end his discussions with Senate Majority Leader Schumer and to kill any hope of enacting even a portion of Mr. Biden’s legislative agenda.

Fifth, Senators Schumer and Manchin announced[iv] their agreement on a spending plan, dubbed the “Inflation Reduction Act,”[v] which will be funded by tax increases[vi] on, and an increase in IRS audits of, wealthier taxpayers.[vii]

Closing Loopholes

With regard to the tax increases, the two Senators stated that “[t]he investments” – a euphemism for “spending” – “will be fully paid for by closing tax loopholes on wealthy individuals and corporations.”

The only “loophole”[viii] addressed in the proposal that may be of interest to certain wealthy taxpayers is the long-maligned carried interest, which you will recall was also a target of Mr. Trump’s tax reform efforts (described below).[ix]

Before considering what has been described as the proposed amendment’s “elimination” of the carried interest, let’s first review the concept and how it was modified by the Tax Cuts and Jobs Act (“TJCA”) in 2017.

Carried Interest

A carried, or profits, or promote interest in a partnership is the right to receive future profits and appreciation in the partnership[x] but does not include a right to receive money or other property upon the immediate liquidation of the partnership.[xi]

In 1993, the IRS issued guidance[xii] that it generally would not treat the receipt of a profits interest for services as a taxable event for either the issuing partnership or the recipient partner. Under this guidance, this favorable tax treatment would not apply, however, if: (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from a high-quality net lease; (2) within two years[xiii] of its receipt, the partner disposes of the profits interest; or (3) the profits interest is a limited partnership interest in a publicly traded partnership.

Subsequent guidance[xiv] clarified that this tax treatment applies with respect to a substantially unvested profits interest provided the service partner takes into income their distributive share of partnership income,[xv] and the partnership does not deduct any amount either on grant or on vesting of the profits interest.[xvi]

Based on the foregoing, the sale of the profits interest, or the sale of its assets by the partnership, after the above-referenced two-year mark would generate long-term capital gain treatment for the profits interest holder.

Tax Cuts and Jobs Act

Toward the end of 2017, the TCJA added a section to the Code[xvii] that sought to make it more difficult for an individual taxpayer to realize long-term capital gain treatment with respect to a profits interest in a partnership received in connection with the performance of services.

Three-Year Requirement

Specifically, the TCJA provided that a three-year holding period requirement had to be satisfied before an individual taxpayer could enjoy long-term capital gain treatment with respect to an “applicable partnership interest” in any “applicable trade or business.”

Moreover, the three-year holding period would apply notwithstanding that the individual may have already included an amount in income upon acquisition of the applicable partnership interest.[xviii]

Thus, the amount of the individual taxpayer’s net long-term capital gain with respect to an applicable partnership interest for a taxable year that exceeds the amount of such gain calculated as if a three-year (rather than a one-year) holding period applies, would be treated as short-term capital gain (taxed at the same rate as ordinary income).


As enacted by the TCJA, the three-year holding period rule does not apply to the individual partner’s income or gain attributable to any partnership asset that is not held for portfolio investment on behalf of third-party investors.

A third-party investor means a person (1) who holds an interest in the partnership that is not property held in connection with an “applicable trade or business” with respect to that person, and (2) who is not and has not been actively engaged in directly or indirectly providing substantial services for the partnership or any applicable trade or business.

Applicable Partnership Interest

An applicable partnership interest to which the extended holding period applies is any interest in a partnership that, directly or indirectly, is transferred to (or held by) the taxpayer in connection with the performance of services in any applicable trade or business.[xix]

An applicable partnership interest does not include an interest in a partnership that is directly or indirectly held by a C corporation; a partnership interest held by an S corporation is not excluded from the term ‘‘applicable partnership interest.’’

Nor does it include an interest held by a person who is employed by another entity that is conducting a trade or business (which is not an applicable trade or business) and who provides services only to the other entity.

Of course, an applicable partnership interest also does not include any capital interest in a partnership giving the individual partner a right to share in partnership capital commensurate with the amount of capital contributed (as of the time the partnership interest was received),[xx]  or commensurate with the value of the partnership interest that is taxed to the individual on receipt or vesting of the partnership interest.[xxi]

Applicable Trade or Business

An “applicable trade or business” means any activity that consists in whole or in part of the following: raising or returning capital, and either identifying, investing in, or disposing of, specified assets, or developing specified assets.[xxii]

For purposes of this rule, “specified assets” means securities,[xxiii] commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to such securities, commodities, real estate, cash or cash equivalents, as well as an interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing.[xxiv]


If a taxpayer transfers any applicable partnership interest to a person “related” to the taxpayer,[xxv] then the taxpayer must include in gross income as short-term capital gain so much of the taxpayer’s net long-term capital gain for such taxable year attributable to the sale or exchange of an asset held for not more than three years as is allocable to the interest.[xxvi]

Targeting Profits Interests

The TCJA’s efforts to limit the profits interest fell short in the eyes of Democrats.

During the 2020 Presidential campaign, they called for the complete elimination of the favorable tax treatment accorded profits interests.

The then newly elected President’s Build Back Better Plan proposed to treat certain profits interests as ordinary income and to impose employment taxes on the income and gains from those interests.

As we know, the President’s Plan did not fare too well, either in its initial or subsequent iterations.

In fact, until the surprise announcement last week, it seemed that the Democrats would be going into the mid-term elections[xxvii] without having enacted any of the Administration’s tax proposals.

The Schumer-Manchin Proposal

According to the one-page summary issued by Mr. Schumer’s office, the Inflation Reduction Act will make the ultra-wealthy pay their fair share, in part by “closing” the carried interest tax loophole, effective for taxable years beginning after December 31, 2022.

Let’s see what’s behind the above statement.

First, although the Senators’ proposal amends portions of the “anti-profits interest” provision added to the Code by the TCJA, it leaves intact, for the most part, the key terms and definitions used in that provision.

That said, it adds a new term – “net applicable partnership gain” – to clarify the kind of gain and income to which the anti-profits interest rules apply; for example, any amount included in gross income with respect to a profits interest and that is treated as capital gain or subject to tax at the rate applicable to capital gain, such as qualified dividends.[xxviii]

Second, the Senators’ proposal increases from three years to five years the holding period requirement that must be satisfied by the individual to whom a profits interest has been issued before the individual may enjoy long-term capital gain treatment with respect to such interest.

In what is probably a meaningless gesture, the proposal will not apply the longer holding period to a taxpayer with an adjusted gross income of less than $400,000,[xxix] though it appears the start of such period may be delayed (see below).

However, the proposal also retains the three-year holding period (subject to a delayed start date) in the case of income with respect to any profits interest that is attributable to any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Third, the proposal delays the start of the new five-year holding period until the latest of (i) the date the individual acquired “substantially all” of the profits interests with respect to which the amount in question was realized, and (ii) the date on which the partnership in which the profits interest is held acquired “substantially all” of the assets held by such partnership.

Query what is meant by “substantially all” the interests or assets? One has to wonder how these will be interpreted by taxpayers and how the government will seek to administer them uniformly.

Fourth, it retains the exception for income or gain attributable to any partnership assets that are not held for portfolio investment on behalf of third-party investors. In other words, “operating businesses” will not be restricted in their use of profits interests.

Fifth, the Senators propose that upon any transfer of a profits interest by a partner, regardless of the transferee’s relationship with the partner, “gain shall be recognized” (presumably by the transferor) notwithstanding any otherwise applicable nonrecognition provision.

This anti-transfer provision is much broader than the existing one, described earlier. It covers all transfers, including, for example, gifts to family, and tax-deferred contributions to a corporation. Moreover, the gain to be recognized is not limited to gain or income realized during the year of the transfer.

That said, it is not entirely clear to what gain the provision refers – presumably, the gain inherent in the profits interest at the time of its transfer, which raises the issue of valuation.

Based on the foregoing, and notwithstanding certain open items, it does appear that the profits interest will lose much of its luster if the two Senators have their way.

However, recent history tells us they should hold off on celebrating just yet.

We’ve Come a Long Way – Have We?

You may recall that the President’s Build Back Better Plan began as a $3.5 trillion tax increase in 2021.[xxx] By the fall of 2021, it had been reduced to approximately $2 trillion. Earlier this year, there were discussions around a proposal with about $1 trillion in new taxes. The Manchin-Schumer deal calls for about $450 billion in new taxes.

Many of the tax increases supported by Senator Schumer did not make it into the proposed “Inflation Reduction Act.” For example, the proposal to expand the 3.8 percent surtax[xxxi] to the active business income that partnerships and S corporations pass through to their owners who earn more than $400,000. The same goes for the so-called “millionaires’ surcharge” and the increase in the long-term capital gain rate.[xxxii]

Even assuming the Senate Parliamentarian gives the green light for a vote on the Inflation Reduction Act, Senator Sinema – who joined Manchin last year, and again earlier this year, to oppose any tax increases – has not yet taken a position on last week’s deal though, previously, she has not supported the elimination of the carried interest. Query whether she will stand alone on her side of the aisle when the time comes. Senate Republicans are certainly hoping that she does.

Speaking of time, the clock is ticking for Senate Democrats – they have only until the end of the current fiscal year (September 30, 2022) to pass legislation by a majority vote,[xxxiii] using the reconciliation procedure to circumvent the filibuster.

That’s “progress” for you.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] House Speaker Pelosi and some colleagues plan to leave for Asia on Friday. Query whether her itinerary will include The Republic of China (aka Taiwan). The People’s Republic has very clearly expressed its disapproval of any such visit, and Russia recently announced its support for the PRC’s “One China” principle.

[ii] The House permits remote voting; the Senate does not.

[iii] Including a smattering of campaigning and fundraising, no doubt.

[iv] The text of their joint statement may be found here: .

A one-page summary may be found here: .

[v] As if the name will miraculously correct the situation in which we find ourselves. In fact, a preliminary study of the bill released Friday by the Penn Wharton Budget Model indicates it will have little-to-no impact on inflation. .

[vi] According to Senator Manchin, “his staff shaved about $400 billion to $500 billion in other revenue-producing tax reforms from the bill.” .

The Senator spent Sunday morning with reporters explaining that the bill does not include tax increases – it closes loopholes.

I wonder how Senator Sinema will see it. I’m certain that Republicans are wondering how she sees it.

[vii] The proposed legislation, which is 725 pages long, is now being reviewed by the Senate Parliamentarian – described by Schumer as “the parliamentary birdbath’ – to ensure that it may be considered under the reconciliation process, by which the evenly divided Senate may pass the bill without any Republican support. This process may take a while.

Meanwhile, Republicans are accusing the Dems of pulling a fast one – specifically, they claim they would not have supported the “chips and science” bill, which passed the Senate on a bipartisan basis just one day earlier, if they had known about the spending plan.

[viii] According to Merriam-Webster, a “loophole” is an ambiguity or omission in the text of a statute through which the intent of the statute may be evaded. Query whether the carried interest meets that definition. In any case, calling it a loophole, conveys the desired negative connotations about those who benefit from the carried interest.

[ix] See the Tax Cuts and Jobs Act of 2017, P.L. 115-97; IRC Sec. 1061. . My goodness, they’re rowing in the same direction?

[x] The capital account rules anticipate the grant of such an interest by permitting the adjustment of capital accounts in connection with the grant of an interest in the partnership (other than a de minimis interest) as consideration for the provision of services to or for the benefit of the partnership by an existing partner acting in a partner capacity, or by a new partner acting in a partner capacity or in anticipation of being a partner. Reg. Sec. 1.704-1(b)(2)(iv)(f)(5)(iii).

[xi] By contrast, a partnership capital interest (which entitles the recipient partner to a share of the proceeds if the partnership’s assets were sold at fair market value and the proceeds were distributed in liquidation) received for services is includable in the partner’s income under IRC Sec. 83, dealing with the receipt of property for the performance of services.

[xii] Rev. Proc. 93–27.

[xiii] The original “holding period” for a profits interest, before 2018.

[xiv] Rev. Proc. 2001–43.

[xv] In the case of an unvested capital interest, an election under IRC Sec. 83(b) would have been necessary to achieve this result.

[xvi] See also the ‘‘safe harbor’’ election under proposed regulations regarding the application of section 83 to the compensatory transfer of a partnership interest. REG–105346–03, 70 Fed. Reg. 29675, May 24, 2005.

[xvii] IRC Sec. 1061.

[xviii] As ordinary income in an amount equal to the FMV of the interest; under IRC Sec. 83(a) in the case of a vested interest, or pursuant to a timely election under IRC Sec. 83(b) in the case of a non-vested interest.

[xix] The services may be performed by the taxpayer or by any other related person or persons in any applicable trade or business.

The provision does not supply a definition of a related person for purposes of the rule defining an applicable partnership interest in IRC Sec. 1061(c)(1). According to the Blue Book, it is intended that for this purpose a related person means a related person within the meaning of IRC Sec. 267(b) or Sec. 707(b).

[xx] For example, in the case of a partner who holds a capital interest in the partnership with respect to capital they contributed to the partnership, if the partnership agreement provides that the partner’s share of partnership capital is commensurate with the amount of capital contributed (as of the time the partnership interest was received) compared to total partnership capital, the partnership interest is not an applicable partnership interest to that extent.

[xxi] IRC Sec. 83.

[xxii] Developing specified assets takes place, for example, if it is represented to investors, lenders, regulators, or others that the value, price, or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider or of others acting in concert with or at the direction of a service provider. Services performed as an employee of an applicable trade or business are treated as performed in an applicable trade or business for purposes of this rule.

[xxiii] A security for this purpose means any (1) share of corporate stock, (2) partnership interest or beneficial ownership interest in a widely held or publicly traded partnership or trust, (3) note, bond, debenture, or other evidence of indebtedness, (4) interest rate, currency, or equity notional principal contract, (5) interest in, or derivative financial instrument in, any such security or any currency, and (6) position that is not such a security and is a hedge with respect to such a security and is clearly identified.

[xxiv] A partnership interest, for purposes of determining the proportionate interest of a partnership in any specified asset, includes any partnership interest that is not otherwise treated as a security for purposes of the provision (for example, an interest in a partnership that is not widely held or publicly traded).

[xxv] This was aimed, in part, at gift transfers of profits interests to trusts for the benefit of the partner’s family.

[xxvi] The amount included as short-term capital gain on the transfer is reduced by the amount treated as short-term capital gain on the transfer for the taxable year under the general rule of the provision (to avoid double-counting).

[xxvii] About 100 days from now.

[xxviii] Although the language is omitted from the text of the proposal, the intended reference must be to “long-term” capital gain.

[xxix] Query how this fits into the President’s promise not to raise taxes on anyone making under $400,000 a year.

[xxx] Do you recall Sen. Sanders calling for $10 trillion?

[xxxi] IRC Sec. 1411.

[xxxii] Other notable omissions include: raising the top individual rate to 39.6% from 37%; nearly doubling the capital gains rate, to 39.6% for those earning $1 million or more; the end of the step-up in basis at death; ending the like kind exchange for real estate.

[xxxiii] Assuming a 50-50 split, with the Veep casting the tie-breaking vote. Finally, something she can do.