IRS to bar S corporations from carried interest exception

The IRS announced on March 1 (Notice 2018-18) that it intends to write regulations that would not allow partnership interests held through an S corporation to qualify for an exception to new carried interest rules on long-term capital gain treatment.

The Tax Cuts and Jobs Act created a new version of Section 1061 to require taxpayers who receive partnership interests in exchange for certain investment and real estate services (typically referred to as "carried interests") to hold any associated assets for three years instead of one to receive long-term capital gains treatment. But Section 1061(c)(4)(A) provides that the new rules do not apply to "any interest in a partnership directly or indirectly held by a corporation." Some taxpayers had already begun exploring whether holding a partnership through an S corporation would qualify them for this exception. Notice 2018-18 is meant to shut down this planning strategy.

The move is not unexpected. Treasury Secretary Steven Mnuchin had already publicly declared that the IRS planned to close what he characterized as a loophole. Although Congress may not have intended to make the exception available to S corporations, the statutory language itself does not explicitly preclude them. Notice 2018-18 provides no explanation or basis for the IRS's interpretation that the exception is limited to C corporations. It simply states that the IRS plans to issue regulations providing that the use of the word "corporation" in Section 1061(c)(4)(A) does not include S corporations, and that the IRS intends for this provision to be effective for taxable years beginning after Dec. 31, 2017, the same general effective date as Section 1061.

Partnerships covered by the new rules should take the new holding period requirements and the IRS position on S corporations into consideration when planning investment strategies and structures.

Contacts Grace Kim
Washington National Tax Office
+1 202 521 1590

Bryan Keith
Managing Director
Washington National Tax Office
+1 202 861 4116

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