IRS Issues Notice on Carried Interests Held by S Corporations

Many questions have already arisen with respect to the newly-enacted Tax Cuts and Jobs Act.  As the IRS begins the process of releasing guidance in order to answer these questions, it is important that taxpayers stay current.  Recently, the IRS issued Notice 2018-18[1], its first piece of guidance under the Tax Cuts and Jobs Act.  In Notice 2018-18, the IRS stated that it intends to issue regulations providing that the term “corporation” for purposes of Section 1061(c)(4)(A) does not include an S corporation.

Carried interests, which are also known as profits interests, are partnership interests issued to a person in exchange for services.  These interests have been used for many years to recognize and reward “sweat equity”.  If structured properly in compliance with existing IRS guidance (Rev. Proc. 93-27[2] and Rev. Proc. 2001-43[3]), the issuance of a profits interest is not taxable to the recipient partner and, as the corollary to that rule, the issuing partnership will be precluded from claiming a deduction with respect to the grant of such interest to the service partner.  The rules governing the initial issuance of a profits interest were not affected by the Tax Cuts and Jobs Act.

In recent years, private equity funds and hedge funds that often manage millions of dollars of portfolio investments for investors have utilized these carried interests as a means of compensating fund managers.  Since these funds manage assets, most of which are capital assets, these fund managers effectively receive compensation taxed at long term capital gains rates for their services.  This has raised the ire of many politicians and others in recent years.

The Tax Cuts and Jobs Act added new Code § 1061 which provides that any gains recognized by the holder of certain types of carried interests that would otherwise be treated as long term capital gains, will instead be treated as short term capital gains taxed at rates applicable to ordinary income unless the assets that generated such gains were held in excess of three years (as contrasted with the normal one year plus one day minimum holding period for eligibility for long term capital gain treatment).

Section 1061(c)(4)(A) provides that the term “applicable partnership interest” shall not include any interest in a partnership directly or indirectly held by a “corporation.”  Consequently, the question was quickly raised whether an S corporation is exempt from the new three year rule because an S corporation is treated as a “corporation” for many purposes under the Code.

In its first guidance under the Tax Cuts and Jobs Act, the IRS, in Notice 2018-18, expressly stated that the regulations will provide that the term “corporation” in Section 1061(c)(4)(A) will not include an S corporation, and as such, S corporation’s will be subject to the three year holding period imposed by new Section 1061.

While the IRS quickly has come out with its position that it will not treat an S corporation as a corporation for purposes of the Section 1061(c)(4)(A) exception, many taxpayers and practitioners have already objected to this on the basis that the IRS simply lacks the authority to not treat an S corporation as a corporation under Section 1061(c)(4)(A) given the express language of the statute and the treatment of S corporations as “corporations” for many other purposes under the Code.  Consequently, it is likely that this position may very well be litigated unless addressed in a technical corrections bill.

[1] 2018-12 IRB 1.
[2] 1993-2 CB 343.
[3] 2001-2 CB 191.