Manchin Drops Tax Reform Bombshell

While waiting for the proverbial ink to dry on the Senate’s vote on the bill to boost the U.S.’s competitiveness with China, Senator Joe Manchin, in what many perceive to be a master manipulation, announced that he struck a deal with Senator Majority Leader Chuck Schumer on the Inflation Reduction Act of 2022 (IRA). The mere suggestion that he would support the IRA sent shock waves through Congress and the public, as the bill, which presumably would need to be passed by reconciliation, goes beyond reducing prescription drug prices and expanding Affordable Care Act (ACA) subsidies. In addition to increased IRS funding, the IRA includes bare bones tax provisions: a corporate alternative minimum tax (AMT) based on book income, which resembles in part the provision in the House-passed Build Back Better Act (BBBA) and was previously discussed here; more stringent carried interest rules, which were excluded in the final House-passed BBBA, while an alternative approach was included in the Biden Administration’s fiscal year 2022 Green Book (discussed here) and carried forward in the fiscal year 2023 proposals (discussed here); and various energy incentives. The net effect of the total investments and the revenue raisers is approximately $300 billion in deficit reduction.

Corporate Alternative Minimum Tax

The IRA would impose a 15% AMT on “applicable corporations” — corporations (other than S corporations, regulated investment companies (RICs), and real estate investment trusts (REITs)) with an average annual adjusted financial statement income (AFSI) for a three-taxable year period greater than $1 billion, based on the current single-employer aggregation rule. However, if the corporation is a member of a foreign-parented international financial reporting group, the corporation would be an applicable corporation only if the $1 billion threshold is met, including all foreign corporations, and a $100 million threshold is met, excluding all foreign corporations (unless the corporation itself is foreign).

However, there are two notable changes to the version in the BBBA:

• For purposes of calculating a corporation’s AFSI, adjustments would be made regarding defined benefit pension plans.
• For purposes of determining whether a corporation satisfies the AFSI threshold, in general, the AFSI would be computed without regard to adjustments for partnership income and defined benefit pension plans. In the case of a foreign-parented group, the AFSI would be computed without regard to adjustments for partnership income; foreign income, including a limitation to include only effectively connected income; and defined benefit pension plans.

A&M Insight: Unfortunately, many of the questions that arose when the House passed the BBBA are still unaddressed. For example, when will a corporation that previously qualified as an applicable corporation lose its status and how will a corporation apply the tax if its financial reporting year differs from its taxable year? Additionally, there are several traps for the unwary, including the possibility that certain income of foreign corporations would be subject to the AMT twice. With that said, the IRA does not include the BBBA’s proposed changes to the aggregation rules and so the corporate AMT is less likely to affect private equity structures.

Carried Interest

Generally, under current carried interest rules, certain net-long term capital gains are recharacterized as short-term capital gains for a partner that holds one or more applicable partnership interests (APIs). However, there are several notable changes to the current rules proposed in the IRA:

• The carried interest rules would be expanded to include income that is subject to tax at capital gains tax rates (e.g., qualified dividend income), as well as applying to a partnership interest that is received in connection with performing substantial services with respect to a section 1061 applicable trade or business (i.e., raising capital and investing in or developing certain assets), even if the entity the services are provided to and the partnership whose interest was transferred to the taxpayer are different.
• Instead of the current three-year holding period, a taxpayer’s net applicable partnership gain would be treated as short-term capital gain for amounts realized after the five-year period beginning on the later of the date on which the taxpayer acquired substantially all of its APIs with respect to which the amount is realized or the date on which the partnership in which such API is held acquired substantially all of its assets. The shorter three-year holding period would still apply to taxpayers (other than a trust or estate) with adjusted gross income of less than $400,000 and for any API that is attributable to a real property trade or business.
• A taxpayer would immediately recognize gain on any transfer of an API, irrespective of any other provision of the Code, as opposed to the current rules which only requires the recognition of gain that would be characterized as short-term capital gain upon the transfer of an API to a related person.

A&M Insight: The proposed changes to carried interest could have a substantial effect on private equity or venture capital funds that engage in significant add-ons or to operating (or other) partnerships that experience high turn-over in their assets. Additionally, like the corporate AMT, many of the questions that arose when carried interest changes were initially proposed remain unanswered. For example, how do you measure whether the “substantially all” requirement is satisfied for purposes of measuring the holding period. With that said, the proposal, while harsher than the current carried interest rules, is more lenient than Senator Ron Wyden’s carried interest proposal from last year.

Energy and Climate Provisions

The IRA supports investments in energy security and climate change solutions, including investing in a broad range of clean energy solutions — hydrogen, nuclear, renewables, fossil fuels, and energy storage — along with investments in technologies to reduce domestic methane and carbon emissions and in enhancing our energy infrastructure. Credit provisions in the bill include:

• Clean Electricity and Reducing Carbon Emissions
  • Extension and modification of credit for electricity produced from certain renewable resources
  • Extension and modification of energy credit under section 48
  • Increase in energy credit for solar and wind facilities placed in service in connection with low-income communities
  • Extension and modification of credit for carbon oxide sequestration under section 45Q
  • Zero-emission nuclear power production credit

• Clean Fuel
  • Extension of incentives for biodiesel, renewable diesel, and alternative fuels
  • Extension of second-generation biofuel incentives
  • Sustainable aviation fuel credit
  • Clean hydrogen credit

• Clean Energy and Efficiency Incentives for Individuals
  • Extension, increase, and modifications of nonbusiness energy property credit

• Clean Vehicles
  • Clean vehicle credit
  • Credit for previously owned clean vehicles
  • Credit for qualified commercial clean vehicles
  • Alternative fuel refueling property credit

• Investment in Clean Energy Manufacturing and Energy Security
  • Extension of the advance energy project credit
  • Advanced manufacturing production credit

• Incentives for Clean Electricity and Clean Transportation
  • Clean electricity production credit
  • Clean electricity investment credit
  • Cost recovery for qualified facilities, qualified property, and energy storage technology
  • Clean fuel production credit

A&M Tax Says

Undoubtedly, the Democrats aim to push the IRA through the reconciliation process at warp speed. However, it is worth noting that passage in the Senate is not guaranteed as Senator Kyrsten Sinema, who has previously said she will not support any tax rate increases, has not weighed in on whether she would support the minimum tax or the carried interest changes, which she had previously opposed. Also, without a provision addressing the state and local tax deduction cap, some members of the “No SALT, No Deal” coalition may try to shut down the legislation as proposed. If the IRA does become law in typical reconciliation fashion, the various grants of regulatory authority for the tax provisions will hopefully be duly exercised to provide required clarifications. A&M will continue to monitor tax reform advances and provide timely updates on new developments. If you would like to discuss your situation or the potential tax changes, including modeling scenarios or identifying planning opportunities, please feel free to contact Kevin M. Jacobs.

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