By: Dan M. Smolnik

On March 1, 2018, IRS released Notice 2018-18 announcing that Treasury and IRS intend to issue regulations providing guidance on the application of Code §1061, enacted under P.L 115-97 to S corporations. This new statute section treats carried interests of fund managers.

Some background is important. Code Section 1061(a) states that, if one or more applicable partnership interests are held by a taxpayer at any time during the tax year, the excess (if any) of (a) the taxpayer’s net long-term capital gain with respect to such interests for such tax year, over (b) the taxpayer’s net long-term capital gain with respect to such interests for such tax year computed by applying paragraphs (3) and (4) of Section 1222 by substituting “3 years” for “1 year,” shall be treated as short-term capital gain. Such gain is taxable at the holder’s marginal income tax rate, which may be as high as 37% (plus the 3.8% net investment income tax, if applicable).

Section 1061(c)(1) defines “applicable partnership interest” as any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the taxpayer’s performance of substantial services, or any other related person, in any applicable trade or business. An “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 investment or disposition), or (ii) developing specified assets. The term “specified assets” means securities, commodities, 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.

Section 1061(c)(4)(A) provides that the term “applicable partnership interest” does not include any interest in a partnership held directly or indirectly by a corporation. (emphasis added).

Being able to continue to treat carried interest as a capital gain, at a 20% rate is an advantage to a fund manager, of course, so access to the exemption under Section 1061 has become notably important to hedge fund managers.[1] It is not clear that the increase of the holding period to qualify for capital treatment will actually have much effect, though, as the average holding period for private equity is around 6 years.[2]

So, it appears that managers are hoping that placing carried interest in a single member LLC, then electing to have the LLC treated as an S corporation, will qualify them for exemption from the three-year holding period to access capital gain treatment.

Notice 2018-18 states that regulations will be forthcoming that provide that the term “corporation,” as used in Code section 1061(c)(4)(A) does not include an S corporation, the plain language of the statute notwithstanding. While Section 1061(f) authorizes Treasury to issue regulations “as is necessary or appropriate to carry out the purposes of this section,” it offers no further guidance.

Consider that the interpretation promulgated in Notice 2018-18 proposes treatment, for this purpose, of an S corporation as an individual. This is not without precedent. In Rev. Rul. 93-36, the Service held that certain bad deduction rules, while generally not applicable to corporations, apply to S corporations because of the “same manner” device used in Code §1363(b).[3] The Tax Court has taken a slightly different approach. In Rath v. Commissioner, the court declined to allow Section 1244 loss treatment, which is applicable only to small business corporation stock sold by an individual or partnership, to stock sold by an S corporation.[4]

Also worth noting is that Notice 2018-18 is conspicuously silent on its authority to exclude S corporations from access to Code Section 1061(c)(4)(A). It may be that the Service hopes this preemptive announcement has the effect of discouraging the growing number of fund managers seeking to access treatment as a corporation for purposes of exempting carried interests from higher tax exposure.


[1] According to a report in Bloomberg, there was a 19% increase in LLC filings in Delaware during December of 2017

[2] The New York Times reported this figure in November of 2017.

[3] The revenue ruling states that, but for certain exceptions enumerated in §1363(b), an S corporation’s taxable income is computed in the same manner as an individual’s income. Given that §166 is not specifically listed as an exception to the general rule of §1363(b), the revenue ruling concludes that §166 applies to an S corporation in the same manner as it applies to an individual. Thus, an S corporation must claim a short-term capital loss for its wholly worthless nonbusiness debt.

[4] 101 T.C. 196 (1993)

Tags: Corporate, Tax