IRS Seeks to Close Hedge-Fund Carried-Interest Tax Loophole

(Bloomberg) -- The U.S. Department of Treasury and the Internal Revenue Service issued guidance seeking to close a loophole that hedge-fund managers had been trying to exploit to avoid paying higher taxes on carried-interest profits.

The guidance informs taxpayers that regulations will be issued barring money managers from using S corporations to take advantage of an exemption to new rules for carried interest contained in President Donald Trump's tax legislation, according to a statement Thursday.

But Treasury Secretary Steven Mnuchin told a Senate panel on Feb. 14 that a Bloomberg News story, which detailed how hedge funds created scores of shell companies to work around the new carried-profit rules, prompted him to instruct administration officials to issue guidance on the subject within two weeks.

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 tax break.

“There is no authority going on here,” said Steven M. Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center in Washington. “I don't think the IRS can just read words into the statute the way they want to read them.”

Hedge funds appear to be embracing the maneuver, which requires setting up LLCs for managers entitled to share carried-interest payouts. Four LLCs were created under the name of Elliott Management Corp., the hedge-fund giant run by Paul Singer. More than 70 were established under the names of executives at Starwood Capital Group Management, the private-equity shop headed by Barry Sternlicht.

Read more on how hedge funds planned to dodge new tax rules

President Trump turned carried interest into a rallying cry during his populist presidential campaign, declaring that “hedge fund guys are getting away with murder.” But under pressure from industry lobbyists and exploiting a split among White House advisers, the Republican Congress in December failed to fulfill Trump's promise to end the tax windfall enjoyed by money managers.

The new tax law requires hedge funds and private-equity players to hold investments for at least three years to get the lower capital gains rate, rather than one year under the old law.

The new guidance could put an end to hedge fund managers' plans to create numerous shell companies in Delaware -- corporate America's favorite tax jurisdiction -- to get around the requirement that assets must be held for three years to qualify for a lower tax rate.

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. For federal tax purposes, it's eligible for a tax rate of 23.8 percent -- which includes a 3.8 percent tax on investment income imposed by the Affordable Care Act -- on sales of assets held for at least three years. Otherwise, managers face a top federal income tax rate of 37 percent.

To contact the reporter on this story: Miles Weiss in Washington at mweiss@bloomberg.net.

To contact the editors responsible for this story: Margaret Collins at mcollins45@bloomberg.net, Vincent Bielski, Katherine Burton

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