S Corporations Not Exempted from Applicable Partnership Interest Rule of IRC §1061

The IRS issued guidance promised by Treasury Secretary Steven Mnuchin in his testimony in February before the Senate Finance Committee regarding the carried interest rules added in IRC §1061 by the Tax Cuts and Jobs Act.  Notice 2018-18 provides guidance on regulations the IRS plans to issue in this area.

The carried interest provision of IRC §1361 provides a special three-year rule that will apply to capital gains generated by that interest.  IRC §1361(a) provides:

(a) In general

If one or more applicable partnership interests are held by a taxpayer at any time during the taxable year, the excess (if any) 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 sections [1] 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 interest is defined at IRC §1061(c)(1) -(3) as:

(1) In general

Except as provided in this paragraph or paragraph (4), the term “applicable partnership interest” means 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. The previous sentence shall not apply to an interest held by a person who is employed by another entity that is conducting a trade or business (other than an applicable trade or business) and only provides services to such other entity.

(2) Applicable trade or business

The term “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 investing or disposition), or

(ii) developing specified assets.

(3) Specified asset

The term “specified asset” means securities (as defined in section 475(c)(2) without regard to the last sentence thereof), commodities (as defined in section 475(e)(2)), 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.

The law was aimed at reducing to a certain extent the benefit of structuring a compensation package for a partner who managed the investment to include a profits interest in the partnership rather than taking a fee for the management services.  By doing so, the manager’s income related to managing the partnership could be taxed primarily at the lower long-term capital gain rates. 

While that advantageous treatment would remain in place for qualified dividends, only gains arising from assets held more than 3 years would qualify for the lower rate when this provision applies.

But an issue arose with an exception found at IRC §1061(c)(4)(A) which provides:

(4) Exceptions

The term “applicable partnership interest” shall not include—

(A) any interest in a partnership directly or indirectly held by a corporation, …

Several advisers noted that, based on the language of that provision, if a partner to whom this rule would apply contributed his/her interest to an S corporation wholly owned by that person, the interest would now be excluded from being treated as an “applicable partnership interest.”  Thus, by simply creating an S corporation to hold his/her interest the manager would be able to sidestep the three-year holding rule and continue to receive long term rates on gains for assets held more than one year but which weren’t held more than three years.

The Treasury Secretary was asked about this provision in his testimony before the Senate Finance Committee and promised that the IRS was going to release guidance that would attempt to block this strategy. 

The guidance does little more than simple state the following about the future regulations under this section:

The regulations will provide that the term “corporation” in section 1061(c)(4)(A) does not include an S corporation

The notice goes on to state that these future regulations will be effective for tax years beginning after December 31, 2017, meaning the agency will not allow those who formed corporations before this notice was issued to obtain the sought-after treatment.

Some advisers have questioned if, in fact, the IRS has the authority to administratively limit the definition of corporations in this provision.  That may be a moot point if Congress includes a specific provision limiting this rule to applying only to C corporations in a technical corrections bill later this year. Otherwise it seems very possible that this question may eventually be decided in court.