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Forthcoming Regulations to Close “S Corporation” Loophole Under New Carried Interest Rules


Section 1061 of the Internal Revenue Code, added by the “Tax Cuts and Jobs Act” (hereafter simply referred to as the “Act”)[1], imposes a new three-year holding period for gains derived by a partnership that are passed through to the holder of a carried interest (or gains from the disposition of a carried interest) to qualify as long-term capital gains.  This change is effective for any allocations of income or sales of carried interests on or after January 1, 2018, and it applies to newly-granted carried interests and existing carried interests alike.

More specifically, section 1061(a) provides that with respect to an “applicable partnership interest” held by a taxpayer at any time during the taxable year, the excess of (1) the taxpayer’s net long-term capital gain with respect to such interests for such taxable year, over (2) the taxpayer’s net long-term capital gain with respect to such interests for such taxable year computed by applying paragraphs (3) and (4) of section 1222 by substituting “3 years” for “1 year,” shall be treated as short-term capital gain, notwithstanding section 83 or any election in effect under section 83(b). An “applicable partnership interest” is 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.[2]  An applicable trade or business is 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 (a) investing in (or disposing of) securities, commodities, real estate held for rental or investment, cash or cash equivalents, or options and derivative contracts (or identifying such assets for investing or disposition), or (b) developing such assets.[3] A typical carried interest, which is common among private equity funds, hedge funds, family offices, and similar investment partnerships, is an “applicable partnership interest.”  

Section 1061(c)(4)(A) provides that any interest in a partnership directly or indirectly held by a corporation is not an “applicable partnership interest” for purposes of section 1061. Until now, there has been uncertainty as to whether the term “corporation” for purposes of section 1061(c)(4)(A) includes an S corporation.  In Notice 2018-18, the Department of the Treasury and the IRS announced their intent to issue regulations providing guidance on the application of section 1061, and specifically their intent that those forthcoming regulations will provide that the term “corporation” for purposes of section 1061(c)(4)(A) will not include an S corporation.  As a result, taxpayers will not be able to avoid application of the three-year holding period imposed by section 1061 on their carried interests by repositioning the ownership of the interests in an S corporation.

Koley Jessen continues to monitor the IRS guidance regarding the Act. Please contact us with any questions.

[1] The “Tax Cuts and Jobs Act” is the the name commonly given to: An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, P.L. 115-97.

[2] I.R.C. § 1061(c)(1).

[3] See I.R.C. § 1061(c)(2) - (3).

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