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IRS Extends Three-Year Carried Interest Holding Period to S Corporations

(Parker Tax Publishing March 2018)

The IRS announced that it intends to issue regulations providing guidance on the application of Code 1061, which was enacted as part of the Tax Cuts and Jobs Act of 2017 and which is aimed at curtailing the "carried interest" tax break available to investment fund managers. According to the IRS, the regulations will provide that the exception for corporations to the longer three-year holding period that must be met in order to obtain capital gains tax rates will not apply to S corporations. Notice 2018-18.

The Tax Cuts and Jobs Act of 2017 (TCJA), which was signed into law on December 22, 2017, made changes to the carried interest tax break, effective for tax years beginning after 2017. Carried interest is the portion of an investment fund's returns that is paid out to investment fund managers. A partnership tax structure is typically used for investment funds because that tax vehicle will provide flow through treatment of income, expense, gains, and losses. Prior to TCJA, carried interest gains on assets held for a year or more were taxed at the more favorable long-term capital gains tax rates. TCJA enacted Code Sec. 1061, which provides that an investment fund's assets must be held for three years before the carried interest payment to an investment manager is taxed at long-term capital gain tax rates.

The three year holding period applies to "applicable partnership interests." Code Sec. 1061(c)(1) generally defines the term "applicable partnership interest" as meaning any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. This rule does not apply to an interest held by a person who is employed by another entity that is conducting a trade or business (other than an applicable trade or business) and only provides services to such other entity.

The term "applicable trade or business" is defined in Code Sec. 1061(c)(2) to mean any activity conducted on a regular, continuous, and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of (1) raising or returning capital, and (2) either (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition), or (ii) developing specified assets.

The term "specified asset" is defined in Code Sec. 1061(c)(3) to mean securities (as defined in Code Sec. 475(c)(2) without regard to the last sentence thereof), commodities (as defined in Code Sec. 475(e)(2)), real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnerships proportionate interest in any of the foregoing.

Under Code Sec. 1061(c)(4)(A), the term "applicable partnership interest" does not include any interest in a partnership directly or indirectly held by a corporation. Code Sec. 1361(a)(1) provides in general that the term "S corporation" means, with respect to any tax year, a small business corporation for which an election under Code Sec. 1362(a) is in effect for such year. Code Sec. 1361(a)(2) provides in general that the term "C corporation" means, with respect to any tax year, a corporation which is not an S corporation for such year.

In Notice 2018-18, the IRS said it intends to issue regulations which provide that, effective for tax years beginning after December 31, 2017, the term "corporation" in Code Sec. 1061(c)(4)(A) does not include an S corporation. Thus, an S corporation cannot be used to get around the three-year holding period rule.

Observation: It's worth noting that some practitioners are questioning whether the IRS has the authority to issue regulations which are seemingly at odds with the plain meaning of the statute. This could be an area ripe for a legal challenge.

For a discussion of Code Sec. 1061 and the carried interest rule, see Parker Tax ¶21,500.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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