The Treasury Department moved Thursday to crack down on hedge funds that try to game the new tax law to gain a tax break for “carried interest,” by issuing a guidance that warned the latest maneuvering by some in the industry isn’t legitimate.
The new guidance from the Treasury Department and the IRS came just two weeks after reports that hedge funds were setting up Delaware LLCs to try to avoid the new tax law’s limitations on carried interest income, which concerns earnings for partners that are taxed at the lower investment income rate rather than at the higher income tax rates.
The Trump-signed tax overhaul contained a provision meant to take the carried interest tax preference away from some of the relatively few hedge funds that benefit from it. The new law requires partners to hold stakes in companies for at least three years before being eligible for the lower tax rate that applies to investment income.
“We worked expeditiously to take this first step to clarify that S corporations are subject to the three year holding period for carried interest,” Treasury Secretary Steven Mnuchin said in a statement. “Treasury and the IRS stand ready to implement the Tax Cuts and Jobs Act as Congress intended and provide the appropriate taxpayer guidance on how the law will be implemented.”
The practice in question was the move by some hedge funds to register as S corporations, rather than partnerships, based on the perception that the law allowed for corporations to accrue carried interest, even as such earnings were limited for partnerships.
But Thursday’s guidance says that the limitation applies to S corporations as well.
Most carried interest income is earned by private equity investors, who hold interests in companies for longer periods of time. Hedge funds generally cycle through investments more quickly. Democrats have sought to have private equity managers’ income taxed at the higher rate for labor income. On the campaign trail, President Trump suggested that he shared that goal, but the legislation only included the more modest three-year restriction.
Mike Sommers, President and CEO of the American Investment Council that represents the private equity industry, welcomed Thursday’s move by the administration. “We appreciate the Treasury Department’s new guidance and believe it correctly clarifies the intent of the law on this tax provision,” he said in a statement.
