The focus by the Senate on curbing profits by hedge funds and limiting stock buybacks could also foretell how other regulators, such as the SEC, may set their priorities ….The agency is “tightening [it’s reviews of FINRA to] focus on ‘performance measures,’ ‘deficiencies’ and ‘corrective actions.
The Inflation Reduction Act (IRA), the revised version of President Biden’s Build Back Better proposal, may have had many investment managers, and financial advisors worried. That’s because one iteration of the legislation proposed significant changes to Section 1063 of the Internal Revenue Code (aka also the tax code). Section 1063 involves how investment managers who take partnership interests in their investments book that profit. At one point, the IRA would have changed the carried interest period from three to five years, a significant change that would have had negative consequences on investment practices.
The good news is that the version of the bill that passed the House of Representatives on August 12, 2022 did not have this language. Procedure dictates that the version last passed is what ends up on the President’s desk and becomes law. Meaning that these changes won’t impact how investment managers carry certain income. However, it’s important to take note that they ended up in legislation that passed the Senate. How far these changes traveled could portend future changes and a renewed emphasis in enforcement actions. For that reason, we thought it was important to dig in a little bit to the proposed changes, the history of them, the focus of the IRA and how it may show the SEC’s interest in future regulations and enforcement actions.
The actual language of Section 1063 is a bit confusing. Suffice it to say, long term capital gains are subject to a preferential 20% federal tax rate (plus additional amounts in some circumstances). Short term capital gains are subject to a graduated rate based on ordinary income taxes and reach a maximum level of 37% (plus the same additional amount in the same circumstances). The key is that a capital gain will be considered long term (with the preferential tax rate) if it is derived from a sale of a capital asset that has been held for more than three years. The previous statutes deemed the long-term status to occur with a shorter holding period: it was one not three years. These holdings are often referred to as “carried interests” as they involve partnership percentages that are held by investors over time. “This requirement applies to carried interests in many private equity funds, hedge funds and other alternative asset management funds.”
Back in 2020, the IRS began creating new regulations to implement the changes required by the Tax Cuts and Jobs Act of 2017. The IRS’s final regulations issued in 2021 differed from the proposed ones announced in 2020. “Compared to the approach taken in the Proposed Regulations, the Final Regulations adopt a more flexible approach to the capital interest exception that attempts to take into account standard market practices.”
The law applies to a somewhat narrow range of interests. It applies only to specified assets, which include “securities, commodities, real estate held for rental or investment, cash and cash equivalents, options and derivative contracts on these assets, and an interest in an underlying partnership to the extent of the partnership's interest in these specified assets.” The regulation also only applies to individuals who are compensated for their work with a partnership interest in an applicable trade or business. Interests in real estate properties that are sold are not subject to section 1061, because they aren’t a business. Interests in real estate companies are disposed of will be. “Generally, Section 1061 pulls within its scope many investment partnerships, but will impact hedge funds more often than PE funds given the fact that most PE funds hold investments for more than three years.”
If the IRS was loosening the grip on the carried interest regulations, why would changes requiring a longer period now appear in the proposed legislation? The changes to the law may have been part of an effort to dig into profits made by hedge funds as part of a populist zeitgeist. The IRA includes other changes to investment practices that are intended to protect employees and investors. For example, the IRA takes aim at stock buybacks. In theory, the premise behind making stock buybacks tax disadvantaged is that “instead of completing share repurchase programs, companies should reinvest the cash directly into their business by improving their products or services, granting workers higher wages and better benefits.” Whether changing tax treatment to stock buybacks has that impact remains to be seen.
Additionally, the changes to 1063 were removed from the IRA when Senator Sinema argued that changing these rules could have negative impacts on small businesses. “The senator argued that, without changes to the bill, small and medium-sized businesses that happen to be owned by private equity firms would be exposed to the tax, violating a Democratic pledge to hike taxes only on the largest firms.”
The focus by the Senate on curbing profits by hedge funds and limiting stock buybacks could also foretell how other regulators, such as the SEC, may set their priorities. A recent report noted that the SEC is increasing its oversight of FINRA. The agency is “tightening [it’s reviews of FINRA to] focus on ‘performance measures,’ ‘deficiencies’ and ‘corrective actions.’” This change may show an increase in SEC actions and changes to regulations. Advisors may want to keep an eye out for new regulations and be ready to answer questions from commercial clients.
These articles are prepared for general purposes and are not intended to provide advice or encourage specific behavior. Before taking any action, Advisors and Plan Sponsors should consult with their compliance, finance and legal teams.
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