On March 1, the IRS announced in Notice 2018-18 that it will issue regulations to prevent S corporations from using an exception to the three-year holding period requirement associated with carried interests. The taxation of carried interests was changed in the 2017 tax legislation (TCJA), to treat gain on the sale of carried interests as short-term capital gain if sellers do not meet the holding period requirement. The IRS announcement would close a loophole these sellers might use to dodge the carried interest legislation.
The three year holding period of the TCJA states that it applies to an “applicable partnership interest.” But one particular exclusion from the definition of an applicable partnership interest is the issue here. The law as written states:
[T]he term “applicable partnership interest” shall not include — any interest in a partnership directly or indirectly held by a corporation.”
This statement does not clearly include or exclude S corporations from the definition of a “corporation.” In common usage, “corporation” is frequently used to indicate a C corporation, and this is essentially the basis of the IRS position on the issue.
The problem with that approach is that it is not clear from other Code sections or judicial interpretations that the use of the word “corporation” should exclude S corporations. Section 7701 of the Internal Revenue Code states that “the term ‘corporation’ includes associations, joint stock companies, and insurance companies.” This broad definition does not appear to support the IRS position. Nor do the Department of the Treasury’s own regulations support the IRS position, as the Treasury defines “corporation” in a similarly expansive definition.
The statutory basis the IRS appears to be relying on for its position is Section 1361, which sets parameters for what is included and excluded from the definition of an S corporation. This provision states that “the term ‘C corporation’ means, with respect to any taxable year, a corporation which is not an S corporation for such year.” It also defines an S corporation as “a small business corporation for which an election (to be an S corporation) is in effect for such year.” A Treasury official said on March 2 that the Treasury will explain its position under Section 1361 when it releases proposed regulations.
This definition appears to be problematic for the IRS in that the definition of an S corporation includes “a small business corporation” (emphasis added). Furthermore, practitioners have noted that the Treasury does not have the authority to change the definition of the term “corporation” for purposes of the carried interest rules. The expansive definition from Section 7701 is applicable to the entirety of the Internal Revenue Code, unless specific intent that it should not apply is shown. Here the portion of the statue at issue does not evidence any clear intent to restrict the definition of a corporation to C corporations.
Another factor that weighs against the IRS is that the legislative history to the TCJA, along with Joint Explanatory Statement (JES) from the Conference Committee that reconciled the House and Senate bills to create the final version of the TCJA, do not show clear intent to limit the section’s definition of “corporation” to C corporations. This will become more relevant if litigation is pursued to prevent the IRS from utilizing the restrictive C corporation definition it indicated in its recent announcement. This is because the courts generally will give deference to an agency’s interpretation only if the interpretation is not unreasonable and Congress had not spoken directly on the issue.
In examining whether the agency’s position is reasonable and not contrary to Congressional intent, the court will generally look at the statute at issue and any related statutes. As discussed earlier, the statute at issue and the related definitional provisions appear to show that Congress has spoken and that the term “corporation” includes C and S corporations. If a court finds that Congress has not clearly spoken on the issue, however, the court is likely to determine Congressional intent by reviewing the legislative history and the JES produced by the Conference Committee that reconciled the House and Senate bills.
Due to the speed at which the TCJA was drafted and passed, there is no extensive legislative history, such as records regarding debate or discussion of certain provisions. In fact, the JES does not define or discuss the term “corporation.” The only relevant language from the JES is:
“[A]n applicable partnership interest does not include an interest in a partnership directly or indirectly held by a corporation. For example, if two corporations form a partnership to conduct a joint venture for developing and marketing a pharmaceutical product, the partnership interests held by the two corporations are not applicable partnership interests.”
Thus, there is no clear indication of Congressional intent to restrict the definition to C corporations.
The final result of this analysis is that there appears to be a reasonable basis to support a taxpayer who takes the position that an “applicable partnership interest” held by an S corporation is not subject to the three-year holding period requirement. Hence, an S corporation could be inserted as a “blocker” between the holder of an applicable partnership interest and the partnership itself, whereby the S corporation becomes the direct holder of the partnership interest and the individual owns shares in the S corporation. Such an arrangement would nullify the new carried interest legislation without changing the underlying economics of the investment, notwithstanding the IRS position it described in Notice 2018-18.
The IRS, however, has made its position clear, so this would be an aggressive position that a taxpayer will need to be willing to defend in litigation. As a result, we strongly recommended that you consult with your CBIZ MHM tax professional before moving forward with the S corporation-owned carried interest “loophole.” For more information on the carried interest legislation and its impact on S corporations, please consult with your local CBIZ MHM tax professional.
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