Important tax proposals included in Democrats’ slimmed-down reconciliation bill

To the surprise of even many on Capitol Hill, Senate Majority Leader Schumer (D-NY) and Senator Joe Manchin (D-WV) announced an agreement on July 27, 2022 on a budget reconciliation bill (the Inflation Reduction Act of 2022, or IRA) that goes beyond what Senator Manchin had indicated he would agree to just a week before. 

The IRA, the tax provisions of which are described more fully below, would:

• Extend expiring Obamacare/healthcare subsidies for three years
• Provide the Centers for Medicare and Medicaid Services the authority to negotiate drug prices
• Expend approximately $370 billion to bolster US energy production and combat climate change through massive increases in renewable energy and carbon emission reduction investments
• Impose a minimum tax on corporate book income, modify the tax treatment of carried interest, and allocate more spending to the IRS for tax enforcement and
• Dedicate $300 billion to federal debt reduction.

Although the IRA is broader than what was being discussed just a short time ago, it does not include many of the provisions that congressional Democrats were hoping for in a budget deal, including an expansion of the deduction for state and local taxes, expanded social programs especially the Child Tax Credit, and some fixes to certain provisions in the 2017 Tax Cuts and Jobs Act. 

Democratic leaders are making the case to their membership that the IRA, especially the healthcare and energy/environmental provisions, will be popular with Democratic constituencies and that approval of this legislation before members go home to campaign in August will give them a boost, along with the recently passed CHIPS bill (legislation designed to subsidize domestic semiconductor manufacturing and invest billions in science and technology innovation). 

Majority Leader Schumer will need the vote of every one of the 50 Democrats in the Senate to pass this bill, and he is hoping that the package was crafted carefully to avoid defections, especially by Senator Kerstin Sinema (D-AZ).  Speaker Nancy Pelosi (D-CA) has only a four-seat margin in the House and, with no Republican support expected, will have to convince Democratic House members not to oppose the bill because some of the provisions they advocated for in the Build Back Better Act were not included in the IRA. 

The Senate is expected to vote on the reconciliation measure next week (the week of August 1), while the House is expected to adjourn for the August recess tomorrow with the intention of returning briefly in August to vote on the measure after the Senate takes its vote.

While there are still hurdles to getting the IRA successfully passed in both chambers, particularly in the House where the Democratic Caucus has been struggling to find cohesiveness in its policy priorities, Democrats are feeling the pressure to produce legislative and policy successes they can use on the campaign trail over the next few months, increasing the likelihood of executing this new iteration of the reconciliation bill.

Below is a more detailed discussion of the tax provisions of the IRA.

Corporate minimum tax

The IRA, if enacted, would codify a corporate minimum tax (CMT) similar to the proposal originally contained in the House Ways and Means Committee’s Build Back Better Act, HR 5376.

The CMT proposal would establish a 15 percent minimum tax on a corporation’s adjusted financial statement income to the extent it exceeds the corporate alternative minimum tax (AMT) foreign tax credit for the tax year. The 15 percent minimum tax would apply to any corporation (other than an S corporation, regulated investment company, or real estate investment trust) whose average annual adjusted financial statement income exceeds $1 billion over any consecutive three-tax-year period preceding the tax year. The proposed minimum tax would require affected taxpayers to perform two separate calculations for US federal income tax purposes and pay the greater of the 15 percent minimum tax or their regular tax liability plus any base erosion and anti-abuse tax (BEAT) liability.  The CMT proposal, if enacted, would apply to taxable years beginning after December 31, 2022.

More detail regarding this proposal can be found at the end of this alert.

“Closing” the carried interest loophole

Individuals who organize and manage investment partnerships (including hedge funds and venture capital funds) to use “carried interests” (ie, ownership interests in a tax partnership that gives the partner a share of profits without having to make a proportionate capital contribution) to convert what the partner would otherwise receive as fee income (taxed at ordinary income rates) into allocations of long-term capital gain realized by the partnership.

The use of carried interests (also called “promotes” or “incentive allocations”) provides significant tax savings to the sponsors of investment partnerships and is pejoratively referred to as the “carried interest loophole.” In 2017, the Tax Cuts and Jobs Act added Section 1061 to the Code to address the “carried interest loophole” by replacing the one-year holding period for favorable long-term capital gain treatment with a three-year holding period. Capital gain caught by the Section 1061 recharacterization rule is treated as short-term capital gain taxable at ordinary income rates.

The IRA would not, contrary to discussions in the media, close the carried interest loophole, but would instead modify the current carried interest rules found in Section 1061 by generally treating a taxpayer’s capital gains from carried interest as short-term capital gains to the extent derived from applicable partnership interests held for less than five years.  Further, while Section 1061 currently looks to the holding period of the asset being sold for determining whether the three-year holding period has been met, as revised by the IRA, Section 1061 would look to the later of (i) the date on which the taxpayer acquired substantially all of its carried interest or (ii) the date on which the partnership in which the carried interest is held acquired all of its assets (with some tiered partnership structures being subject to similar rules).

Section 1061’s current three-year holding period would continue to apply to taxpayers with an adjusted gross income of less than $400,000 and to income with respect to any carried interest that is attributable to a real property trade or business as defined in Section 469(c)(7)(C).  The proposed legislation also would clarify that carried interests held by S corporations are subject to the longer holding period rules of Section 1061 and would replace the existing rules for transfers of carried interests to related persons by requiring a taxpayer to recognize gain on any transfer of a carried interest.

The proposed legislation also would authorize the Treasury Department to issue regulations or other guidance (1) to prevent avoidance of Section 1061 mentioning specifically avoidance through the distribution of property by a partnership and carry waivers and (2) to apply the section to financial instruments and contracts in entities other than partnerships to the extent necessary to carry out the purpose of the statute.  If enacted, these new carried interest rules would apply to taxable years beginning after December 31, 2022.

Funding the Internal Revenue Service and improving taxpayer compliance

 The IRA would increase appropriations for the fiscal year ending September 30, 2022, directing funds to the IRS and the Treasury Department to invest in functions such as services, enforcement, and operations business systems modernization. In addition, certain funds would be directed to the Inspector General for Tax Administration, the Office of Tax Policy, the US Tax Court, and certain departmental offices of the Treasury Department.  It is estimated that the IRA’s proposed increase in funding for IRS and Treasury Department will raise approximately $124 billion of revenue.

This alert is a high-level overview of the tax provisions of the IRA. Those provisions are more complex than as described and are subject to limitations and exceptions that are not addressed in this alert.  Learn more about these provisions by contacting any of the authors.

Appendix: Some additional details about corporate minimum tax

The CMT would impose a tentative minimum tax on applicable corporations on the excess of (i) 15 percent of the adjusted financial statement income (as determined under section 56A) (AFSI), over (ii) the corporate AMT foreign tax credit for the taxable year.

For this purpose, an “applicable corporation” is any corporation (other than an S corporation, regulated investment company, or real estate investment trust), which satisfies an annual adjusted financial statement income (AAFSI) test for one or more taxable years which (i) are prior to such taxable year and (ii) end after December 31, 2021.

A corporation satisfies the AAFSI test for a taxable year, and is therefore an applicable corporation, if (i) the AAFSI of such corporation for the three-taxable-year-period ending with such taxable year exceeds $1 billion and (ii) in the case of a foreign-parented corporation which is a part of an international financial reporting group, such corporation has AAFSI for the three-taxable-year-period ending with such taxable year of $1 billion and the AAFSI of such corporation, determined without regarding to the AAFSI of the international financial reporting group, for the three-taxable-year-period ending with such taxable year exceeds $100 million.

To better understand the application of the AAFSI test, the proposed legislation explains how AFSI should be calculated. Under the proposal, AFSI is defined as, with respect to any corporation for any taxable year, the net income or loss of the taxpayer set forth in the taxpayer’s applicable financial statement (AFS) for such taxable, subject to numerous adjustments.

As discussed above, the AFSI test keys off a taxpayer’s AFS. The proposed legislation defines an AFS as, with respect to any taxable year, an applicable financial statement (as defined in Section 451(b)(3) or as specified by the Treasury in regulations).

Section 451(b)(3) provides that an AFS means a financial statement certified in accordance with generally accepted accounting principles and which is:

• a Form 10-K, or annual statement to shareholders, required to be filed by the taxpayer with the United States Securities and Exchange Commission
• an audited financial statement of the taxpayer which is used for (A) credit purposes, (B) reporting to shareholders, partners, or other proprietors, or to beneficiaries, or (C) any other substantial nontax purpose, but only if there is no Form 10-K or annual statement of the taxpayer described in the previous bullet or
• filed by the taxpayer with any other federal agency for purposes other than federal tax purposes, but only if there is no statement of the taxpayer described in either of the previous two bullets.

IN CASE YOU MISSED

Our Global Tax Reform hub houses related articles covering developments in global tax legislation.