The Internal Revenue Service (IRS) proposed rules on Friday, July 31, 2020 that would restrict a workaround in the 2017 tax overhaul that has allowed some hedge fund managers to avoid a three-year holding period to qualify for preferential capital gains rates on carried interest.
Carried interest is the compensation - on top of regular fees - that general partners in private equity funds, hedge funds, and other private investment funds receive as an incentive to improve a fund’s performance.
The Tax Cuts and Jobs Act of 2017 (TCJA) addressed the taxation of “applicable partnership interests.” Under the provision, if one or more “applicable partnership interests” were held by a taxpayer at any time during the tax year, some portion of the taxpayer’s long-term capital gain with respect to those interests may be treated as short-term capital gain. At a high level, the provision requires that to obtain long-term capital gain treatment for applicable partnership interests, the required asset-holding period must be greater than three years.
After the TCJA was enacted, some hedge fund managers began setting up S Corporations in states including Delaware and PFICs (passive foreign investment company) as an end run around the three-year holding period.
The Proposed Rule
The proposed rules under Internal Revenue Code Section 1061 disallow the use of S Corporations and PFICs to avoid the requirement that the carried interest must be held for at least three years, instead of one year as under previous law, for taxation under preferable long-term capital gains tax rates, rather than ordinary income rates.
The rules followed a 2018 notice issued by the U.S. Department of the Treasury that said forthcoming regulations would not allow S Corporations to avoid the three-year holding period.
Some practitioners have questioned whether the government has the authority to close the workaround, saying the statute specifically makes an exception to the three-year holding period for interests held by a corporation.
Treasury and the IRS had concluded they had the authority to make the change under the law.
In addition, the IRS proposed that the rule not apply to capital gains from the sale of property used in a trade or business under Section 1231, contracts marked to market under Section 1256, and certain qualified dividends and other types of capital gains that are characterized as long-term.
Very few asset managers converted to an S Corporation to take advantage of what they thought will allow them to escape the three years rule for capital gain treatment. For the ones who did, they will need to file an amended return.
For more information or to set up a meeting to discuss how Citrin Cooperman can provide assistance with hedge fund tax compliance, please reach out to Jean-Paul Schwarz at email@example.com.