Democrats are in the midst of negotiating a sweeping tax and spending bill and are considering a bevy of tax proposals aimed specifically at asset management. The provisions could have a dramatic impact on hedge funds, private equity funds, mutual funds, exchange traded funds, real estate investment trusts, business development companies and other investment structures.
Negotiators are drawing from a wide range of proposals—including the tax title from the reconciliation bill recently approved by the House Committee on Ways and Means Committee—in addition to several discussions drafts and bills authored by Senate Finance Committee Chair Ron Wyden, D-Ore.
While many of these proposals are likely to change in the coming weeks and months—and certain proposals and bills may not ultimately become law—Democratic leaders are seeking to enact major legislation containing many of these proposals before the end of this year. Asset managers have an opportunity to perform pre-emptive planning, seize rate arbitrage opportunities and mitigate the impact of unfavorable proposals.
Capital gains rate increase
The House reconciliation bill would raise the top rate on long-term capital gains and qualified dividends from 20% to 25%. A 3% surtax would also apply to the extent capital gains income increase AGI above a $5 million threshold. The 25% rate would generally apply to gain from transactions occurring and dividends paid after Sept. 13, 2021. There is a grandfathering rule for transactions pursuant to a written binding contract in place on or before Sept. 13, 2021, and which is not modified in any “material respect.”
The statutory language does not specifically define “written binding contract,” but this phrase has been used in transition rules before. The bonus depreciation regulations generally defined a written binding contract as a contract that is enforceable under state law and does not limit damages to a specified amount.
Grant Thornton Insight: Democrats have retreated significantly from President Joe Biden’s 39.6% proposed capital gains rate, but an increase of five percentage points still cuts significantly into after-tax proceeds of many investments. Investors may want to emphasize gain offset planning, including harvesting tax losses, leveraging charitable deductions, and using deferral or gain exclusion strategies such as opportunity zones or like-kind exchanges. If the effective date of the proposed rate increase is delayed during negotiations, taxpayers could also consider accelerating gains.
The House bill would amend Section 1061 to increase the holding period from three years to five years to receive long-term capital gains treatment on certain carried interests in investment services partnerships. Taxpayers of all filing statutes with AGI of $400,000 or less (except estates and trusts) would retain the three-year holding period. In addition, the bill would make meaningful changes to the start date for the holding period.
Specifically, under the proposal, the holding period would be measured from the later of the date on which (1) the taxpayer acquires “substantially all” of the partnership interests or (2) the date on which the partnership acquires “substantially all” of the assets. Note, however, the proposal does not define “substantially all.”