IRS, Treasury Clarify Rules on Carried Interest, but It Might Be Too Late

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In guidance issued Thursday, U.S. Treasury Secretary Steven Mnuchin and the IRS told taxpayers that regulations yet to be issued will not allow them to avoid the three-year holding period by establishing a pass-through “S corporation” to dodge an oversight in the tax law passed last December.

When Congress passed the tax law changes, it left some holes that smart accountants and tax attorneys leapt on without hesitation. One of the more publicized of those holes was a provision that would have allowed a hedge fund or private equity fund partner to set up an “S corporation” to avoid taxes on business profits paid to the partner. The holding period is commonly, and mystifyingly, known as “carried interest.”

Under the new law, fund managers who share in fund management profits must hold those profits for three years in order to qualify the profits as capital gains and then pay the capital gains rate of 20% rather than the top individual tax rate of 37%. Under the old law, the holding period was one year.

The new law does not, however, impose the three-year holding period on assets owned by a corporation. Several clever clogs figured out that setting themselves (or their clients) up as an “S corporation” could dodge the three-year wait. Not so fast, say the Mnuchin and the IRS.

Mnuchin said:

We worked expeditiously to take this first step to clarify that S corporations are subject to the three year holding period for carried interest. Treasury and the IRS stand ready to implement the Tax Cuts and Jobs Act as Congress intended and provide the appropriate taxpayer guidance on how the law will be implemented.

That train may already have left the station though. The issue is whether Treasury and the IRS fix in regulation something that is clearly missing from the law that makes no distinction between “S corporations” and “C corporations,” and it is arguable whether the distinction can be inserted after the fact. The guidance issued today¬†applies to tax years beginning after December 31, 2017.

Not everyone is persuaded. Steve Rosenthal of the Tax Policy Center told The Wall Street Journal it lacks support in the law and is plainly at odds with the words of the statute. He said he would advise clients to disclose to the IRS what they’re doing with “S corporations” and be ready to be challenged. In the end, he said, “You’re likely to win.”