There’s a looming possibility of legal challenges to Treasury’s position on a tax break for hedge fund and private equity managers, now that the government has issued proposed rules.
The proposed rules would prevent S corporations from taking advantage of a 2017 tax law provision that lets corporations get the favorable carried interest tax treatment faster—by holding assets for one year rather than three. The rules reignite a question about Treasury’s legal authority to exclude S corporations from the meaning of “corporations” in the provision, a question that has already been raised in at least one court case and has been on the minds of experts since Treasury first indicated its plans in a 2018 notice.
If Treasury pushes forward with final regulations, and they are struck down by a court, private equity and hedge fund managers may try to employ S corporations to get the better tax treatment after just one year, although some may find certain restrictions on S corporations too burdensome.
Congress, when lengthening the holding period in the tax overhaul, may only have wanted to exempt C corporations because they pay taxes at both the corporate and shareholder levels, as opposed to S corporations, which pass income through to shareholders for tax purposes. But multiple tax specialists told Bloomberg Tax that, even if this is true, a court may conclude that Treasury can’t exclude S corporations given the broad language Congress used in the statute.
Carried interest is the portion of an investment fund’s returns that is paid to managers. It is taxed at a preferential rate of 20%, generally accompanied by an additional 3.8% net investment income tax, versus the top individual rate of 37%.
“The statute on its face says corporations, and I believe ‘corporations’ includes S corporations,” said Steve Rosenthal, a senior fellow in the Urban-Brookings Tax Policy Center at the Urban Institute. “Admittedly that’s a loophole, but I think Congress needs to close the loophole, not Treasury, not the IRS.”
Treasury didn’t return a request for comment.
One appeals court has already suggested Treasury’s planned move could face legal trouble.
In Charleston Area Medical Ctr. v. United States, the U.S. Court of Appeals for the Federal Circuit sided with Treasury’s argument for interpreting “corporation” broadly in a different part of the tax code. But the court’s October 2019 ruling also questioned whether Treasury’s planned rules, as signaled in the 2018 notice, would be proper given Treasury’s broad interpretation of “corporation” in that separate case dealing with a different code section.
Whether final rules from Treasury come under court scrutiny likely depends on whether a taxpayer pursues the S corporation strategy and then challenges the rules. Some suggested there will likely be a taxpayer willing to take the department to court.
“In my experience anything that is unambiguously anti-taxpayer gets challenged because there’s always somebody with enough money at stake,” said Howard Abrams, a visiting professor at Harvard Law School who specializes in partnership and corporate tax issues.
“Fidelity to the law would say that Treasury should lose” in a court challenge, Abrams said. He pointed to the tax code’s general definition of “corporation” under Section 7701(a)(3) as well as the code’s definition of “S corporation” under Section 1361 as indicating that an S corporation is a corporation.
Treasury, however, does have arguments on its side. Longstanding case law supports the idea that Treasury has broad regulatory authority to interpret the meaning of the tax law, although some judges have pushed more recently for limiting such authority, said Alexander Anderson, a partner at O’Melveny & Myers LLP who focuses on tax issues.
Multiple tax professionals suggested that some courts could be persuaded by the view that Treasury should be able to fix an apparent drafting error or that the policy arguments favor Treasury.
In explaining its authority to issue the rules, Treasury said it has been instructed under Section 1061(f) to issue regulations or guidance that is “necessary or appropriate to carry out the purposes” of the law.
The department also noted that the definition of “corporation” in the Joint Committee on Taxation’s blue book, which was created to explain the law after its enactment, “does not include an S corporation.”
But some questioned the blue book’s usefulness to Treasury in a future court case.
“Besides the fact that courts don’t normally give much credence to the blue books because they’re post-enactments, the blue book just has a conclusory statement with no reasoning behind it,” said Monte Jackel, a tax expert and former special adviser to the IRS chief counsel.
Treasury’s justifications come at a time when the department has ramped up its explanations for major rules, as it faces a growing threat of lawsuits challenging their validity.
Anderson said that Treasury’s discussion of its regulatory authority in the proposed rules “was a bit conclusory and not exactly a bulletproof defense,” but cautioned against reading too much into it. “They may have a stronger case that they haven’t laid out in the proposed rules, and I also think that getting too deep into the discussion would look overly defensive.”
—With assistance from Allyson Versprille.