In short: The U S Inflation Reduction Act of 2022 introduces potential new tax provisions and new taxes including energy efficiency credits, a tax increase for corporations, closing the carried interest loophole and more.
On July 27th, 2022, key senate Democrats announced a deal on a budget reconciliation bill, the Inflation Reduction Act of 2022 (“IRA”), that would spend roughly $369 billion on clean energy and climate investments while also reducing the federal deficit by over $300 billion in the next ten years. The revenue-raising provisions included in the proposed legislation are a 15% minimum tax on large corporations, reforms to prescription drugs’ pricing, new spending for IRS enforcement activities and projects and changes to the taxation of carried interests. Many of these proposals were previously incorporated in the Build Back Better Act, which stalled on the Senate floor after being passed by the House of Representatives in November 2021. The most notable tax provisions for individuals and businesses are summarized below.
15% Corporate Minimum Tax
The largest revenue raiser included in the Inflation Reduction Act is a proposed 15% minimum tax that would apply to the domestic profits of large corporations with average adjusted financial statement income greater than $1 billion over the previous three years. Corporations that are part of a controlled group would be required to aggregate the adjusted financial statement income of all members of the group in applying the $1 billion test. The threshold would be lowered to $100 million for foreign-parented corporations that are members of an international financial reporting group with average financial statement income in excess of $1 billion over the applicable three-year period.
Adjusted financial statement income is currently defined as the net income or loss reported on the taxpayer’s applicable financial statement for the tax year, with adjustments for consolidated returns, disregarded entities, dividends received from related corporations and certain foreign items. Other adjustments to financial statement income may also be included in future versions of the IRA or in subsequent Treasury regulations if the bill is signed into law. While critics of the bill warn that the minimum tax provision could result in earnings manipulation, many companies will likely be hesitant to disappoint investors by artificially reducing earnings reported in their financial statements for tax saving purposes.
Corporations subject to the tax would be eligible to claim net operating losses and tax credits to offset the minimum tax increase. Further, a tax credit would be allowed for minimum tax paid in prior years if in a later year the corporation’s regular tax liability exceeds 15% of adjusted financial statement income. The minimum tax provision would be effective for tax years beginning after December 31, 2022.
Taxation of Carried Interests
Section 1061 of the Internal Revenue Code, enacted in 2017 as a part of the Tax Cuts and Jobs Act, made it significantly more difficult for holders of carried interests to receive long-term capital gain treatment on income attributable to the carried interest. The proposal in the IRA aims to go even further in limiting the favorable tax treatment of carried interests for investment managers of hedge funds, private equity funds, and real estate funds (previously called a “carried interest loophole”). Under current law, a carried interest must be held for at least three years for a “net applicable partnership gain” (derived from a disposition of the partnership interest itself or certain assets held by the partnership) to be treated as a long-term capital gain by the holder. The IRA would increase this required holding period to five years, with the exception that the three-year period would continue to apply to real property trades or businesses and to individuals with adjusted gross income of less than $400,000.
In addition to the increased length of the required holding period, the holding period would not be deemed to begin until the later of the date that the holder acquires substantially all of the applicable partnership interest, or the date that the partnership acquires substantially all of its assets. As a result, if a fund were to acquire its assets over multiple years, the five-year holding period would not start until the end of the asset acquisition phase.
Notably, the IRA proposal would also expand the definition of a net applicable partnership gain to include other allocations of income that would normally be taxed at long-term capital gain rates for a carried interest holder, including Section 1231 gains and qualified dividend income. Thus, gains from property sales attributable to a promote issued by a real estate fund would now be required to meet the Section 1061 holding period requirements to qualify for long-term capital gain treatment. The changes to carried interest taxation would be effective for tax years beginning after December 31, 2022.
As part of its goal to combat climate change, the IRA provides for roughly $260 billion in clean-energy tax credits that will be available to both businesses and individual taxpayers. This includes the extension of existing tax credits as well as the implementation of new credits for activities that were not subsidized under prior law. A few highlights of the energy tax incentives created by the IRA are listed below:
- Extension of the Section 45 production tax credit (“PTC”) and the Section 48 investment tax credit (“ITC”) for eligible projects, including wind and solar energy.
- A new two-tier credit structure for the PTC and ITC generally consisting of a base rate of 20% of the current credit amounts and full credit eligibility if prevailing wage and apprenticeship requirements are met.
- Additional “bonus” tax credits for PTC and ITC projects that satisfy domestic content requirements or are located in low-income communities and former fossil fuel employment hubs.
- New credits for energy storage, clean energy production, clean hydrogen production, renewable energy production and advanced manufacturing of components and materials necessary for clean energy production.
- Extension of the $7,500 tax credit for purchase of a new electric vehicle and creation of a new $4,000 credit for the purchase of a used EV, while eliminating the cap on number of vehicles sold per manufacturer. Eligibility for EV tax credits would be limited to single taxpayers with income below $150,000 and joint filers with income below $300,000 ($75,000 and $150,000, respectively, for the used EV credit).
- Authorization for the sale of certain clean energy tax credits between unrelated parties, which would allow taxpayers with little or no tax liability to benefit from the generation of new tax credits.
What’s Next for the Inflation Reduction Act?
The Inflation Reduction Act is still in proposed form as of the date of this writing, and will need to pass in both the Senate and the House before it can be signed into law by President Biden. The bill is currently under review by the Senate parliamentarian/joint committee and will likely require the vote of every Senate Democrat to achieve the simple majority needed under budget reconciliation. Democrats also have just a slim majority in the House, where some moderates may be disappointed by the omission of a provision reinstating the state and local tax (SALT) deduction. The coming weeks will be crucial in determining the ultimate fate of this proposed legislation.
If you have questions regarding the proposals included in the Inflation Reduction Act of 2022 and how they might affect your individual tax situation, please contact your Bennett Thrasher tax advisor by emailing firstname.lastname@example.org.