Synopsis

The Internal Revenue Service (IRS) recently announced the Treasury Department’s intention to issue income tax regulations clarifying that S corporations will be subject to the extended three-year holding period for “applicable partnership interests”, i.e., carried interests. IR-2018-37 and Notice 2018-18.  The regulations, when issued, will be effective for tax years beginning after December 31, 2017. 

Background

Partnership interests are often issued to investment fund managers in connection with the manager’s services. These interests, commonly referred to as “carried interests,” are ownership interests in a partnership that entitle the partners to a share in the partnership’s net profits. Prior to the enactment of the Tax Cuts and Jobs Act (“the Act”), capital gains arising from a carried interest qualified for long-term capital gain treatment if held for more than 1 year.  The Act changed the holding period required to qualify for long-term capital gain treatment from one to three years.   IRC §1061. 

In addition to increasing the above noted holding period requirement, the Act included an exception, essentially providing that a partnership interest directly or indirectly held by a corporation would not be subject to the new three-year holding period requirement. Based on this language, it appeared that a partner could simply contribute their carried interest to an S corporation that he/she owns to avoid this new holding period requirement.  

IRS regulations will prevent circumvention of three-year holding period

To cure this legislative oversight, the IRS formally announced, in IRS Notice 2018-18, its intention to issue new tax regulations that will provide that the term “corporation”, as used in IRC Section 1061, would not include an S corporation. This regulation, if enacted, would prevent taxpayers from using S corporations to avoid the extended holding period. 

What does CohnReznick think?

While we believe that this specific issue was likely a drafting error, some fund managers have been considering utilizing S corporations within their structures to potentially benefit from the law as written. In recent comments before the Senate Finance committee, Treasury Secretary Mnuchin stated that “taxpayers will not be able to get that loophole.”  IRS Notice 2018-18 signals the Treasury’s intention to take immediate action on this specific issue. However, regardless of the Treasury’s assertions that this issue can be addressed via regulations, we believe that it is not clear whether the Treasury has the authority to accomplish what they intend via a regulation.  Arguably, due to the specific language in the Act, a technical correction may ultimately be required to cure this oversight.  

Visit our previous alert, The Tax Cuts and Jobs Act: Carried Interest Year-End Tax Considerations, for additional background information on this topic.

Contact

Robert Richardt, Partner

646-625-5736

Jon Collett, Partner

959-200-7228

Rony Rodriguez, Partner

310-966-2303

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