IRS Restricts Carried Interest Tax Break Used by Hedge Funds

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

The change, published Friday, bars money managers from using some types of business entities, including S corporations and passive foreign investment companies, to take advantage of an exemption to rules for taxing carried interest.

“The Treasury Department and the IRS have concluded that the grant of regulatory authority in section 1061 is sufficient for the government to issue regulations” exempting S corporations and PFICs, the rule states, referring to the relevant tax code section in the 2017 law.

The rule addresses what some experts see as a mistake in the tax overhaul, which has allowed hedge fund managers to avoid paying higher taxes on investments.

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.

The 2017 law increased the time that hedge funds and private equity managers had to hold 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 law exempted corporations from having to hold assets for a longer time period before qualifying for the preferential tax rates. Hedge funds found a way to use that exemption by setting up 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, given that the tax law doesn't include a limitation on the type of corporations that can access the tax break. A U.S. Court of Appeals ruling suggested the same.

The regulations are politically sensitive. President Donald Trump, before the 2017 tax law, vowed to end the tax break. The overhaul ultimately scaled back the benefits for carried interest, rather than repealing them entirely.

A proposed Democratic bill to end the carried interest tax break can't pass without unified control of the House, Senate and White House. The proposal could also face some opposition from within Democratic ranks.

Still, repealing those tax breaks is popular among progressive Democrats. The carried interest break is relatively small for a tax expenditure -- costing about $14 billion over a decade.

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