On March 1, the IRS and Treasury announced their intent to issue regulations addressing the new carried interest rules enacted as part of tax reform. More specifically, they intend to clarify that the new rules apply to certain partnership interests held by S corporations.
In an attempt to close what many view as a loophole in our tax laws, Congress added section 1061 to the Internal Revenue Code of 1986, as amended (the “Code”) in the recently enacted Tax Cuts and Jobs Act. In general, the new Code section increases the required holding period for long-term capital gain treatment with respect to partnership interests held by investment and fund managers. Under section 1061, if a taxpayer holds an “applicable partnership interest” during the tax year, the taxpayer’s net long-term capital gain with respect to such interest is only treated as long-term capital gain if the taxpayer has held the “applicable partnership interest” for more than three years—instead of more than one year. If the three-year holding period is not satisfied, the gain is treated as short-term capital gain, which is subject to the same tax rates applicable to ordinary income.
Under section 1061, an “applicable partnership interest” means any interest in a partnership which is transferred to or held by the taxpayer in connection with the performance of substantial services by the taxpayer in a business of raising or returning capital and either investing or disposing of specified assets or developing specified assets. “Specified assets” means securities, commodities, real estate held for rental or investment, cash or cash equivalents, and options or derivative contracts with respect to the foregoing.
The new rules include two exceptions: an “applicable partnership interest” does not include (1) any capital interest in a partnership that entitles the taxpayer to share in partnership capital commensurate with contributed capital or the value of such capital interest, or (2) any partnership interest directly or indirectly held by a “corporation”. Congress did not specify in exception (2) whether “corporation” includes S corporations. As a result, investment fund managers have begun forming S corporations to hold their interests. This allows them to continue to hold their carried interests in a pass-through structure while avoiding the extended holding period requirement. In Notice 2018-18[1], the IRS and Treasury have stated that the regulations they intend to issue under section 1061 of the Code will provide that “corporation” as used in this exception does not include an S corporation. Furthermore, Notice 2018-18 indicates that the clarifying regulation will be effective for taxable years beginning after December 31, 2017. Therefore, any taxpayers who have formed S corporations in an effort to fit within the exception will be subject to the new rules.
One question that remains is whether the IRS and Treasury have the authority to issue such a regulation that would define “corporation” not to include an S corporation for purposes of Code section 1061. When statutory language is unclear, the Treasury may issue interpretative guidance, but if the statute is clear, any regulations issued may not contradict the statutory language. Under most provisions in the Code, the term “corporation” includes an S corporation unless otherwise stated. Section 1061 makes no such distinction. Unless Congress acts to amend section 1061 to clearly settle the matter, there likely will be future litigation over this issue with fund managers arguing that Congress intended S corporations to be included within the exception for partnership interests held by “corporations” under section 1061.
[1] Notice 2018-18, 2018-12 IRB 1 (released March 1, 2018), available here.
