Press Room: Tax Release

March 02, 2018

IRS and Treasury Issue Formal Guidance on New Carried Interest Provision

IRS and Treasury recently issued Notice 2018-18 (the Notice) to close uncertainty in the Tax Reform Act of 2017 (the Act) related to carried interest that could have allowed private equity and hedge fund managers to receive capital gain treatment on carried interest by holding the carry through an S corporation. This development is important information for investment funds, but also involves a cautionary note that is relevant for all taxpayers engaged in tax planning in response to the recent tax reform changes.

Restructuring Strategy Whipsawed by IRS Guidance

The formal guidance, previously announced by Treasury Secretary Steven Mnuchin, clarified that the government will issue regulations stating that to qualify for the lower long-term capital gains rate, the capital gain allocated to the applicable partnership interest must be with respect to property held for more than three years. The holding-period change applies to both the partnership’s holding period in the underlying assets and the partner’s holding period in the partnership interest. The regulations will be effective for taxable years beginning after December 31, 2017.

The Act provided an exception that the applicable partnership interest does not include any interest in a partnership directly or indirectly held by a corporation. Many investment funds have considered an S corporation as a way to circumvent the three-year holding period on carried interest. They may have already formed a single-member LLC, but were waiting until March 15, 2018 to make the S election. According to the Notice, the new regulations will specify that the holding-period exemption applies only to C corporations.

The Takeaway

The Notice is the most recent example of closing unintended loopholes created by the Act by regulation, rather than seeking a technical correction. Taxpayers considering major restructuring in light of tax reform need to understand that IRS will continue to issue guidance to remediate possible loopholes and perceived benefits from tax reform may be dismissed swiftly through similar administrative guidance.