Senate Majority Leader Schumer, Sen. Manchin announce reconciliation tax agreement

In brief

Senate Majority Leader Chuck Schumer (D-NY) and Senator Joe Manchin (D-WV) late on July 27 announced their agreement on a budget reconciliation bill (the Inflation Reduction Act of 2022). According to fact sheets distributed by Senate Democrats, the legislation includes revenue and spending offsets of $739 billion over 10 years by increasing taxes paid by businesses and individuals and by producing savings from changes in federal prescription drug pricing policies. The bill includes $433 billion in spending and tax incentives on energy and climate change provisions and a continuation of expanded Affordable Care Act health care benefits, and the remaining roughly $300 billion would be devoted to deficit reduction. 

The tax increase provisions include a proposed 15% book minimum tax on corporations with profits over $1 billion (effective for tax years beginning after December 31, 2022), and a proposed change in the tax treatment of "carried interest" (effective for tax years beginning after December 31, 2022). The agreement also would provide for an $80 billion increase in IRS tax enforcement funding. The legislation does not include any changes to the cap on the federal individual itemized deduction for state and local taxes.

Majority Leader Schumer announced in a July 27 statement that the text of the proposed legislation would be submitted to the Senate parliamentarian for a review to ensure that bill text complies with Senate budget reconciliation rules, and that he expects that the Senate “will vote on this transformative legislation next week.” The Senate currently is scheduled to begin its August recess at the end of next week; the House is scheduled to begin its recess at the end of this week.

President Biden expressed support for the agreement, which differs significantly from the “Build Back Better” reconciliation bill that was passed by the House last November. "I urge the Senate to move on this bill as soon as possible, and for the House to follow as well," he said in a July 27 statement.

Observation: While the reconciliation process does provide a pathway for the enactment of significant tax and spending provisions with only Democratic votes, changes may be required to the agreement announced by Majority Leader Schumer and Senator Manchin to receive the unanimous support of all 50 Democratic Senators in the evenly divided Senate. In the absence of any Republican support, unanimous Democratic support would allow Vice President Kamala Harris to cast the tie-breaking vote. Last year, a similar carried interest proposal was dropped from the House reconciliation bill in response to opposition from Senator Kyrsten Sinema (D-AZ). Any Senate-passed bill also would require the near-unanimous support of Democrats in the narrowly divided House. 

Action item: Significant tax proposals affecting businesses and individuals may be enacted under budget reconciliation procedures if Democrats can secure the unanimous support of all Senate Democrats. Stakeholders, and especially CEOs and CFOs, should communicate with policy makers on the potential effects of tax increase proposals on their employees, job creation, and investments in the United States. 

The Inflation Reduction Act revenue-raising provisions

Corporate book income minimum tax

The corporate book alternative minimum tax (AMT) proposal would impose a 15% minimum tax on adjusted financial statement income for corporations with average adjusted annual financial statement income over a three-tax year period in excess of $1 billion. Corporations generally would be eligible to claim net operating losses and tax credits against the AMT, and would be eligible to claim a tax credit against the regular corporate tax for AMT paid in prior years, to the extent the regular tax liability in any year exceeds 15% of the corporation’s adjusted financial statement income. 

This provision would be effective for tax years beginning after December 31, 2022.The proposal is estimated by JCT staff to raise $313 billion over 10 years, according to a summary released by Senate Democrats.

A similar provision was included in the “Build Back Better Act” that was passed by the House in November 2021. Unlike the House-passed provision, the Inflation Reduction Act proposal would (1) disregard any book income, cost, or expense with respect to defined benefit pension plans, and (2) include any item of income or deduction included in the computation of taxable income with respect to defined benefit pension plans. 

Observation: The changes to limit the provision’s effect on defined benefit pension plans were first proposed by Senate Finance Chairman Ron Wyden (D-OR) in the Senate Finance Committee’s draft legislation released in December 2021. 

Carried interest 

The carried interest provision revises a House Ways and Means Committee provision to modify Section 1061 that was ultimately dropped from the House-passed Build Back Better Act. Under the Inflation Reduction Act, the proposed changes to Section 1061 and the treatment of carried interest would be effective for tax years beginning after December 31, 2022. The proposal is estimated by JCT staff to raise $14 billion over 10 years, according to a summary released by Senate Democrats.

Current Section 1061, enacted as part of the 2017 tax reform legislation, extends the long-term capital gains holding period with respect to applicable partnership interests (API) from a greater than one-year holding period to a greater than three-year holding period. An API is a partnership interest that is transferred to a taxpayer in connection with the performance of substantial services by the taxpayer or a related person in an applicable trade or business.

The bill generally would extend the long-term capital gains holding period with respect to an API from three years to five years. A three-year holding period would continue to apply to taxpayers (other than a trust or estate) with adjusted gross income of less than $400,000 and to any income with respect to an API that is attributable to a real property trade or business. 

The bill would expand the scope of Section 1061 by introducing the term ‘net applicable partnership gain.’ Net applicable partnership gain generally would be defined as all amounts included in the gross income of the taxpayer with respect to an API that are treated as capital gain or subject to tax at the rate applicable to capital gain. All net applicable partnership gain is subject to recharacterization under Section 1061. Additionally, the bill adds rules for measuring the holding period of both APIs and of assets that give rise to net applicable partnership gain. The holding period would be measured from the later of the date on which the taxpayer acquired substantially all of the API with respect to the amount realized or the date on which the partnership in which the API is held acquired substantially all of the assets held by the partnership. 

Observation: These changes would significantly expand the application and scope of Section 1061. In contrast to the current final regulations under Section 1061, gain determined under Sections 1231 and 1256 and qualified dividend income (QDI) would be subject to recharacterization under Section 1061. Additionally, the clock on the five-year holding period with respect to an API would not begin to run until the holder of the API acquired substantially all of its interest and the partnership acquired substantially all of its assets. A newly admitted partner would not be able to benefit from the long-term holding period of the assets held by the partnership. Gain from the sale of an asset held for the required period would not be eligible for long-term capital gain unless substantially all of the assets of the partnership are held for the required period.

The bill also would rewrite the rules related to transfers of APIs. The bill would be a significant expansion of the application of Section 1061 in connection with transfers of APIs. Under the bill, the provision would apply to all transfers, whether or not the transfer is to a related person and whether or not gain is recognized in the transaction.

IRS funding

The Inflation Reduction Act would appropriate an increase in IRS funding over 10-years as follows:

• $45,637,400,000 for enforcement, 
• $25,326,400,000 for operations support,
• $4,750,700,000 for business systems modernization, and
• $3,181,500,000 for taxpayer services. 

The proposed legislation states that these appropriated funds are to remain available until September 30, 2031, and no use of the funds is intended to increase taxes on any taxpayer with taxable income below $400,000. The provision also provides $15 million for the IRS to prepare and deliver a report to Congress on the cost of developing and running a free direct efile tax return system. The provision permits the Secretary to exercise greater flexibility with respect to personnel, including certain “direct hire” authority.