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Mnuchin’s Pledge to Fix Carried Interest ‘Loophole’ in Question

Posted on February 22, 2018 by Dylan F. Moroses

A gap in the Tax Cuts and Jobs Act allowing hedge funds to avoid a new carried interest rules may not be as easy to fix as Treasury Secretary Steven Mnuchin has suggested. 

Mnuchin recently told the Senate Finance Committee that planned IRS guidance would prevent investment fund managers from using shell companies set up as S corporations to avoid the three-year holding period for assets under the TCJA (P.L. 115-97).

But there is speculation as to whether the IRS has the authority to fix the carried interest exemption language because of the way the tax code defines S corporations. 

Steven Rosenthal of the Urban-Brookings Tax Policy Center said tax code section 1363(b)computes the taxable income of an S corporation in the same manner as an individual, adding that S corps often can take deductions that are permitted to individuals, like the new 20 percent deduction for qualified passthrough business income under section 199A.

However, Rosenthal said Treasury and the IRS cannot stretch section 1363(b) to say S corps are not corporations for purposes of section 1061, which excludes carried interest held directly or indirectly by corporations. Only S corps can benefit from this exclusion, so removing them would defeat its purpose, he said. 

“There’s a misunderstanding of the drafting convention for the meaning of corporation, and I doubt Treasury and the IRS can override the clear language of the exclusion,” Rosenthal said, adding that the “thousands of private equity managers that have been flocking to Delaware” to set up limited liability companies will continue to do so.

But, Barbara Angus, majority chief tax counsel of the House Ways and Means Committee, said February 21 that the statutory language in the carried interest provision referring to corporations is clearly intended to mean C corporations, and not passthrough entities.

“Looking at the use of the word ‘corporation’ in the code, it’s consistently used to mean C corporation when you’re talking about the taxation of the entity, which is how it’s being used in this position in the statute. So, if the statute [isn’t] clear, Treasury has made clear they are willing to issue guidance in case anyone has any doubt about that provision,” Angus said during a Bloomberg event in Washington. 

Carolyn E. Smith of Alston & Bird LLP told Tax Analysts that she thinks the law favors Treasury and the IRS, but that could end up being for the courts to decide. 

“Agencies (and courts) often look to context and the totality of the law in question. In some cases, for example, there are other sections that may give Treasury authority to issue what they consider to be antiabuse rules. Even if they do come out with a rule, as the secretary indicated they would, it could be challenged,” Smith, a former Joint Committee on Taxation staff member, said in an email. 

Some industry groups were quick to support Mnuchin’s pledge even as questions mount regarding Treasury’s authority. 

Mike Sommers, president and CEO of the American Investment Council, said in statement that his group agrees with Mnuchin that the “the intent of the law is clear on this tax provision” and supports the plan for additional guidance to clarify that the carried interest exemption applies only to C corps.

Not the Only Issue

Even if administrative efforts to address the carried interest issue fall short, it's already on the shortlist of priorities identified by congressional taxwriters after the TCJA's passage. Ways and Means Committee Chair Kevin Brady, R-Texas, said his panel would develop a list of provisions that need to be addressed in a technical corrections package, though congressional Democrats have suggested a more measured approach to review those fixes with committee hearings.

Lawmakers have also been working on a way to deal with the disruptions in agricultural markets caused by the section 199A deduction’s treatment of qualifying cooperative dividends. Another issue that's been raised is the TCJA’s omission of qualified improvement property from the list of 15-year depreciation period property.

Tax lobbyists expect those provisions to be high on the list of technical corrections that could be included in spending legislation that must be passed to keep the government running past March 23.

The Republicans’ hope is for Treasury and IRS guidance to fix the problematic aspects of the TCJA, a former Democratic aide said. In an election year, and with a shortage of must-pass bills that can attract Democratic support, the only other alternative may be to wait until lame duck for a technical corrections bill, the former aide said. 

David van den Berg and Lauren Loricchio contributed to this article. 

Follow Dylan F. Moroses(@DMoroses3244) on Twitter for real-time updates.