IRS building in Washington. IRS building in Washington.

The Internal Revenue Service said Wednesday that it plans to issue regulations clarifying limitations on carried interest.

The new tax cut law extended the holding period with respect to certain carried interests (i.e. applicable partnership interests) to three years. The IRS issued Wednesday Notice 2018-18, which states that it will be issuing regulations clarifying that taxpayers will not be able to circumvent the three-year rule by using S corporations.

The regulations will apply to unregistered funds such as hedge funds, not mutual funds.

In order to clarify the intention of the tax code exemption, the new rules are expected to specify that it will only apply to C corporations.

Elliot Galler, a partner on Withers Bergman’s international corporate tax team, said that “if structured properly, managers that have already put their ‘carry’ in an LLC would not have elected S corporation status yet and therefore are not likely to be adversely impacted by the IRS announcement.”

An open question is “whether the IRS has exceeded its regulatory authority in this case,” Galler continued, adding that “it will be interesting to see if any fund managers challenge the IRS and risk having their carry stuck in an S corporation if they lose.”

While the S corporation status, Galler said, “is not dissimilar from operating as an LLC, there are differences that can be important. The action by the IRS on this topic also raises the question of S corporation status with respect to other provisions” of the new tax law.

Carried interests are ownership interests in a partnership that share in the partnership’s net profits, and are often “issued to investment managers in connection with the investment manager’s services,” the IRS states.

“These interests often result in the holder receiving capital gains which are taxed at a lower rate, rather than ordinary income,” according to the IRS.

Attorneys have said that following passage of the tax code reforms, it was reported that many investment fund managers moved to establish S corporations in order to qualify for the corporate exemption and to avoid carried interest.

Under the new tax law, the three-year rule took effect for tax years beginning after Dec. 31, 2017.  Treasury and IRS intend to issue regulations that are also effective for tax years beginning after that date.

Closing the carried interest loophole was one of 39 areas the American Institute of Certified Public Accountants requested immediate IRS guidance on in late January.

— Related on ThinkAdvisor: