IRS puts hedge funds on notice about closing loophole in new tax law
The Internal Revenue Service’s announcement that it plans to issue regulations clarifying the limitations on carried interest serves notice to hedge funds that have been making moves to take advantage of a seeming loophole in the new tax law.
The IRS announced Thursday that S corporations are subject to a three-year holding period for partnership interests and that regulations will be issued soon on that score (see IRS seeks to close hedge-fund tax loophole for carried interest). The Tax Cuts and Jobs Act extended the holding period for certain carried interests to three years from one year. In Notice 2018-18, the IRS said it will be issuing regulations clarifying that taxpayers won't be able to circumvent the three-year rule by using S corporations. Under the tax reform law, the three-year rule took effect for tax years starting after Dec. 31, 2017, so the Treasury and the IRS plan to issue regulations that are also effective for tax years beginning after that date.
Joe Pacello, a tax partner at BDO USA who works with private equity firms and financial institutions, sees an impact on both hedge funds as well as some private equity firms from the IRS announcement. “This deals specifically with an ambiguity in the statutory language,” he said Friday. “They changed the holding period requirement with respect to carried interest so that the general partner or the owner of the carried interest only gets long-term capital gains on their share of transactions to the extent that the underlying portfolio company or security was held at least three years. That’s a significant change from prior law, where they only needed to meet the general capital gain holding period of one year. However, in the final statute there’s an exception for carried interest held by quote-unquote ‘corporations’ so there was some question as to whether that was applicable to only C corps or perhaps S corporations as well.”
However, there have been reports recently about hedge fund managers, who often don’t meet the three-year holding period, setting up limited liability companies in Delaware and inserting the LLCs into their structure with a view toward electing to treat them as S corporations. “The strategy was that they had until March 15, 2018 to make it retroactive to January 1, and they would wait and see what happened with regulations or IRS guidance,” said Pacello. “That was the impetus for that flurry of activity. Then Treasury Secretary [Steven] Mnuchin a few weeks ago telegraphed that the IRS was aware of this strategy and was not happy about it, and was going to address it and basically attack it and shut it down. Yesterday’s notice was the first salvo in that effort. The notice indicates that the Treasury Department is going to issue regulations to the effect that the exception in the law only applies to C corporations and not S corporations.”
It’s not clear yet whether the IRS notice will be enough to shut down that type of activity, or whether hedge funds will find ways to get around it.
“I think at a minimum this is serving notice to the industry that the IRS is going to aggressively attack it on audit,” said Pacello. “But there is an open question as to whether the IRS and the Treasury Department have the authority to issue regulations on this point, particularly when the statute uses sort of plain language. That’s a subject of a lot of debate. I think there may be some aggressive fund managers out there, and practitioners, who intend to still take the position that they can benefit from that exception with an S corp structure, but they would need to disclose it on their tax return, and basically accept the fact that the IRS is going to attack it and challenge it aggressively.”
The courts or Congress may need to be the arbiter in the end. “Ultimately this may wind up having to be decided by the Tax Court,” said Pacello. “The only other possibility is that Congress may step in with some sort of a technical correction.”
However, there’s some skepticism about whether or not a technical corrections bill would be able to pass in Congress to fix the errors in the hastily drafted Tax Cuts and Jobs Act.
“I think there is a lot of skepticism because the reason they were able to get tax reform through in such an expedited way was because they used a budget reconciliation process, so it only required a simple majority in the Senate, 51 votes,” said Pacello. “But the technical corrections, from what I understand, would require a supermajority, which means they would have to get buy-in from Democrats, which in this environment is not going to be easy. I don’t see that happening anytime soon. So you’re left with the statute, and you’re left with the notice. There have been signals from members of Congress that they agree with the Treasury Department, and that the intent of the statute was that the exception would only apply to C corps. But I think this is the sort of thing that may ultimately wind up being resolved by the Tax Court.”
For now, the notice in itself shouldn’t be enough to affect what type of entity businesses choose, although the overall tax law is prompting such considerations.
“I don’t know if it will have that much impact on the structure of the carrier vehicles at this point,” said Pacello. “I think the larger tax reform implications are such that there are a lot of choice of entity considerations now, and they have become more pronounced now with respect to portfolio companies and investment management companies in particular. I think that’s where the choice of entity is going to be more pronounced.”
He pointed out that not only hedge funds, but also some private equity firms and venture capital firms, may be affected by the new notice.
“This provision has more of an impact on hedge fund managers as opposed to private equity because of the longer investment horizon of private equity and venture capital versus hedge funds,” said Pacello. “But there is a little bit of a trap for the unwary with private equity and venture capital if they have follow-on investments, because they may have held the portfolio company for more than three years. But to the extent that they had add-on investments, they could have a bifurcated holding period, some of which could be subject to the ordinary rates for the general partner.”