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Don’t Use S Corps to Avoid Carried Interest Holding Period

IRS to Tax Payers: Don’t Use S Corp to Avoid Carried Interest 3-Year Rule

The fall out from hasty drafting of the massive Tax Cuts and Jobs Act continues, this time with the Department of the Treasury and the IRS moving quickly to plug an unintended loophole involving carried interests. Carried interests are profits interests held by investment fund managers that compensate them for their services and are commonly used by private equity, venture capital and real estate investment funds. The usual model is that the fund managers get a 20% profits interest in the entity. (Click here for a description of carried interests provided by the American Investment Council.)

Longer Holding Period

The new law extended the holding period for capital gains treatment of carried interests from one year to three years. There was concern that the tax bill would treat carried interests as ordinary income. President Trump vowed to end the carried interest “loophole” both during the campaign and after he was elected. However, the final bill retained capital gains treatment for carried interests, but only if they are held for more than three years.

The problem with the final language of the Act is that it says the three-year rule does not apply to “corporations,” leading taxpayers to conclude that they can use S Corporations to get around the longer holding period. Like partnerships, S Corporations are passthrough entities that have a single level of taxation imposed at the shareholder level. In other words, the owners, not the entity, pay tax on the S Corporation’s income. If the three-year holding period does not apply to S Corporations, there is an incentive to use them to run private equity firms.

Treasury Puts on the Brakes

Once this strategy got some press, Treasury and the IRS moved quickly to stop it before many taxpayers adopted it. On March 1, just a little over two months after the bill passed, Treasury released a statement and an official Notice informing taxpayers that IRS regulations will be issued that will not allow them to avoid the three-year holding period by using S Corporations. Furthermore, the regulations will be effective back to January 1, 2018. “We worked expeditiously to take this first step to clarify that S corporations are subject to the three year holding period for carried interest,” said Treasury Secretary Steven T. Mnuchin. “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.”

With a top ordinary income rate of 37% and a top capital gains rate of 20%, capital gains treatment for carried interests represents a significant tax reduction for the compensation paid to private equity and hedge fund managers, even with the three-year rule. As reported in many press outlets, Mike Sommers, president and CEO of the American Investment Council, the private-equity industry’s trade group, welcomed the IRS guidance, stating that it “correctly clarifies the intent of the law on this tax provision.” The three-year rule can be an inconvenience and will make fund managers stick with a firm perhaps longer than they want to. Given that this tax break could have been completely abolished, however, industry leaders appear willing to accept Treasury’s new limitations.

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