Carried Interest Tax Break Restricted in New IRS Regulations

(Bloomberg) -- The Internal Revenue Service released regulations restricting a valuable tax break that hedge fund managers were able to claim after an error in the 2017 Republicans tax law.

The regulations, published Thursday, bar money managers from using business entities, known as S corporations, to take advantage of an exemption to the law’s rules for taxing carried interest.

The regulations address what some tax policy experts see as a mistake in the 2017 tax overhaul that allows hedge fund managers to exploit a loophole to avoid paying higher taxes on their investments. The Treasury Department first issued a statement in early 2018 that signaled plans to change the carried interest rules.

Carried interest is the portion of an investment fund’s returns that are paid to hedge fund and private equity managers, venture capitalists, and certain real estate investors eligible for lower tax rates.

The tax law extended the amount of time hedge funds and private equity managers had to hold their investments -- to three years from one year -- to get the long-term capital gains rate of 20%. Otherwise, they had to pay individual income tax rates, which now top out at 37%.

But the 2017 law exempted corporations from having to hold assets longer before qualifying for the preferential tax rates. Hedge funds found a way to use that exemption by setting up a series of S corporations and limited liability companies for managers entitled to share carried-interest payouts, allowing them to be eligible for the lower rates more quickly. So-called C corporations, the common structure for most publicly traded companies, aren’t subject to the three-year holding period.

Some experts question whether the IRS has the authority to put this restriction in place through regulation, given that the tax law doesn’t include a limitation on the type of corporations that can access the break. A recent U.S. Court of Appeals ruling suggested the same, saying the IRS may struggle to defend the rules in future legal fights.

The carried interest regulations are a politically sensitive issue. President Donald Trump, before the 2017 tax law, vowed to end the tax break, which is popular with some business-friendly members of his party. The overhaul ultimately scaled back the benefits for carried interest, rather than repealing them entirely.

Democrats have for years proposed legislation that would end the carried interest tax break. Those efforts have largely been symbolic because the Democratic-led House couldn’t get the Republican majority in the Senate on board.

However, the tax break could be repealed once Joe Biden becomes president, since Democrats now control both chambers of Congress by thin margins. The carried interest break is relatively small for a tax expenditure -- costing about $14 billion over a decade.