March 7, 2018 Notice 2018-18 announces that S corporations will be subject to new carried interest holding period rule In Notice 2018-18, the IRS announced its intention to issue regulations stating that carried interests held by S corporations will not qualify for the exception from the Tax Cut and Jobs Act's carried interest provision for interests held by corporations. The term "carried interests" generally refers to profits interests issued by partnerships to service providers in connection with the performance of services, a common practice in a wide array of industries in the alternative fund sector (e.g., private equity, venture capital, hedge fund, real estate, and energy). Newly enacted Section 1061 imposes a three-year holding period requirement for long-term capital gains treatment for certain carried interests. According to the Notice, the regulations will, like Section 1061 itself, be effective for tax years beginning after December 31, 2017. Background Section 1061(a) generally provides that, if one or more applicable partnership interests are held by a taxpayer at any time during the tax year, the excess (if any) of (1) the taxpayer's net long-term capital gain with respect to such interests for such tax year, over (2) the taxpayer's net long-term capital gain with respect to such interests for such tax 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. Such gain is taxable at the holder's marginal income tax rate, which may be as high as 37% (plus the 3.8% net investment income tax, if applicable). Section 1061(c)(1) generally defines the term "applicable partnership interest" as any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the taxpayer's performance of substantial services, or any other related person, in any applicable trade or business. An "applicable trade or business" means 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: (A) raising or returning capital, and (B) either: (i) investing in (or disposing of) specified assets (or identifying specified assets for such investment or disposition), or (ii) developing specified assets. The term "specified assets" means securities, commodities, 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 partnership's proportionate interest in any of the foregoing. Section 1061(c)(4)(A) provides that the term "applicable partnership interest" does not include any interest in a partnership held directly or indirectly by a corporation. Notice 2018-18 Notice 2018-18 states that the IRS and Treasury intend to issue regulations providing that the term "corporation" as used in Section 1061(c)(4)(A) does not include an S corporation. The regulations would be effective retroactively for tax years beginning after December 31, 2017, the same date on which new Section 1061 became effective. Implications The issuance of the Notice follows congressional testimony from Treasury Secretary Mnuchin in mid-February in response to questions and reporting about the potential use of S corporations by certain alternative asset managers. Since the passage of the Tax Cuts and Jobs Act (P.L. 115-97), there has been uncertainty as to whether the Section 1061(c)(4)(A) exception will apply to interests held by S corporations. Some taxpayers may have transferred their carried interests to S corporations in anticipation of claiming the benefit of the exception. Other taxpayers may have transferred their carried interests to limited liability companies, currently disregarded as separate entities for federal tax purposes, with a view to potentially causing the limited liability companies to elect retroactively to be treated as S corporations. The statute itself does not explicitly limit the application of the Section 1061(c)(4)(A) exception to C corporations (which, under Section 1361(a)(2), generally include corporations other than S corporations). Section 1061(f) authorizes the Treasury to "issue such regulations or other guidance as is necessary or appropriate to carry out the purposes of this section." The explanation of the House version of the legislation (which was substantially similar to the version ultimately enacted) provides as follows: "The Treasury Department is directed to issue regulations or other guidance necessary to carry out the provision. Such guidance is to address prevention of the abuse of the purposes of the provision, including through the allocation of income to tax-indifferent parties. Guidance is also to provide for the application of the provision in the case of tiered structures of entities." The IRS has in the past, in certain instances, asserted that provisions that generally apply to individuals (but not corporations) apply to S corporations. See, e.g., Revenue Ruling 93-36, 1993-1 CB 187 (ruling that the Section 166(d) nonbusiness bad deduction rules, although in general not applicable to corporations, nevertheless apply to S corporations, because Section 1363(b) generally requires an S corporation to compute its taxable income "in the same manner as in the case of an individual"). In some cases, however, courts have rejected arguments that an S corporation should be treated for tax purposes in the same manner as an individual. See, e.g., Rath v. Commissioner, 101 T.C. 196 (1993) (refusing to extend Section 1244 ordinary loss treatment, which by statute applies only to small business corporation stock sold by an individual or a partnership, to small business stock sold by an S corporation). Because Notice 2018-18 does not indicate the basis on which the IRS and Treasury will seek to exclude S corporations from the Section 1061(c)(4)(A) exception, it may not end the debate over whether S corporations will qualify under the exception or whether such a change requires legislative action. The guidance has, however, put taxpayers on notice as to the IRS's and Treasury's position on the issue. For that reason, Notice 2018-18 may deter many taxpayers from claiming the benefit of the Section 1061(c)(4)(A) exception for interests held by S corporations. ———————————————
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