Paul L. Caron

Thursday, November 7, 2019

Carried Interest Warning From Court May Be Trouble For Treasury

Bloomberg Tax, Carried Interest Warning From Court May Be Trouble for Treasury:

A recent court case meant to clarify the definition of a corporation intensifies questions about the tax treatment of carried interest, a prized perk for private equity and hedge fund managers [Charleston Area Medical Ctr. v. United States (Fed. Cl. Oct. 17, 2019)].

The IRS argued for a broad definition of the term “corporation” in the case. But the legal issue that could come up in the future is whether it’s reasonable for Treasury regulations to interpret the term more narrowly in the carried interest context, affecting who can qualify for the treatment.

That question is even more relevant because Treasury is planning guidance that could close what some see as an error created in the 2017 tax law’s treatment of carried interest. The carried interest perk lets fund managers have much of their income taxed at 23.8% rather than at the top tax rate of 37%.

The tax law exempted corporations from having to hold assets for a longer time period before qualifying for the preferential tax rate. Treasury’s forthcoming rules are expected to shut down the possibility that an S corporation could qualify for the exception. (An S corporation is an entity that isn’t taxed at the corporate level, instead passing income through to shareholders for tax purposes.)

But the U.S. Court of Appeals for the Federal Circuit suggested it isn’t so simple: it said the IRS may struggle to defend the rules in future legal fights.

“I don’t think the IRS is going to win on this one,” said Steve Rosenthal, a senior fellow in the Urban-Brookings Tax Policy Center.

If future regulations are challenged and invalidated by a court, it could leave open the potential for some private equity and hedge fund managers to take on S corporation status and get the preferential tax rate after just one year. To block that strategy, Congress would have to rewrite the provision in the tax law.

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