Friday, March 02, 2018

Treasury plans to close S Corp loophole in TCJA carried interest provision

By Mark S. Nelson, J.D.

The Treasury Department and the Internal Revenue Service issued a notice stating their intent to adopt a regulation that will close a loophole created by the Tax Cuts and Jobs Act (TCJA) (Pub. L. No. 115-97) under which some firms could have set up Subchapter S corporations to avoid the lengthened holding period for long-term capital gains under the TCJA’s carried interest provision. According to Notice 2018-18, Treasury and the IRS expect the regulation be effective for taxable years beginning after December 31, 2017.

TCJA Section 13309 followed both the House and Senate versions of tax reform and lengthened the holding period for favorable capital gains treatment from 1 year to 3 years regarding partnership profits interests held in connection with the performance of investment services. The holding period arises in the context of carried interest, which often impacts hedge funds and private equity funds.

But confusion resulted when the TCJA amendment was read against the backdrop of other Code provisions that suggested the S corporation as a possible vehicle to avoid the longer holding period. Code Section 1061(c)(4)(A) provides that “applicable partnership interest” excludes “any interest in a partnership directly or indirectly held by a corporation.” To close the S corporation loophole, the Treasury regulation will clarify that, with respect to this exception, “S corporation” is not included within the meaning of “corporation.”

Treasury Secretary Steven Mnuchin characterized the Treasury/IRS notice as the “first step” in fixing how the TCJA carried interest provision should be applied in practice. “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,” said Mnuchin.

The TCJA was the largest tax revision effort since the TRA of 1986. Both the House and Senate markups of the TCJA rejected Democrats’ amendments that would have tracked legislation introduced by Rep. Sander Levin (D-Mich) (H.R. 2295) and Sen. Tammy Baldwin (D-Wis) (S. 1020). Both bills would have gone further to close the carried interest loophole by requiring recharacterization of gains or losses from investment ser­vices partnership interests as ordinary income (loss) instead of allowing more favorable capital gains treatment. The Levin and Baldwin bills also included a qualified capital interest exception that would have allowed firms to avoid recharacterization if certain requirements were met.