On February 14, Bloomberg News published an article that quickly made its way around among private investment funds and their lawyers – I received about 10 emails before 9 am from clients. The article discussed a potential structure for general partners of funds (in the article hedge funds, mostly) to get around the new 3 year holding period requirement for carried interest gains to receive long term capital gain treatment (see related coverage here). You can access the Bloomberg article here.

In summary, the article notes that some hedge fund and real estate fund managers are rushing to set up Delaware LLCs to hold their carried interests. These Delaware LLCs would elect to be taxed as “S corporations”; the theory being that the new carried interest legislation does specifically say that the new law does not apply to carried interests held by “corporations” (and therefore the three year holding period would not be required to be met).

While it is technically true that the law mentions “corporations” broadly without distinguishing between “C” corporations (which pay corporate income tax at the entity level at 21% with a second shareholder level tax on dividends) and “S” corporations (which generally pass through their income to their owners so that there is only the shareholder level tax), this idea has been floating around out there since the new law was passed. We have been very skeptical that this would end up being a viable loophole. We have expected that either Congress would pass a “technical correction” which would fix this obvious workaround, or that Treasury and the IRS would issue regulations to do the same thing. The whole situation is an unfortunate byproduct to the legislation being passed with such haste (prior versions of proposals to change the tax treatment of carried interest were much more carefully and thoughtfully drafted).

Well, it turns out that someone in President Trump’s Cabinet is an avid reader of Bloomberg News. In the afternoon after the Bloomberg article was passed, Treasury Secretary Steven Mnuchin announced that indeed this S corporation “dodge” would be shut down and that this gambit would not be available to taxpayers to get around the law. Secretary Mnuchin said:

“We do believe that taxpayers will not be able to get that loophole. We will have that resolved.” He promised the Senate Finance Committee on February 14th that the government would act within two weeks to shut down this potential workaround.

Apparently the Trump Administration is all out of valentines for the private funds industry. Stay tuned to your Cooley team for further developments in the implementation of the new rules on carried interest.

Posted by Cooley