The IRS recently announced plans to “close a loophole,” suggesting that hedge-fund managers have been suddenly trying avoid paying higher taxes on carried-interest profits. This issue, however, is really a non-starter, and should not be getting the coverage that it is.
The IRS wrote a rule that exempts carried interest from a longer holding period when it’s paid to a corporation rather than an individual. But it didn’t specify that it applied solely to regular corporations, whose income is subject to double taxation. What some are ridiculously suggesting is that an S-Corp “loophole” exists to allow a hedge fund manager to treat a two- or three -year capital gain as long- term. That is a joke.
When the IRS wrote the rule, they said it applies for all flow-thru, but not corporations. The reason why is because corporations don’t have capital gains rate. So if you have a hedge-fund manager for a corporation, they pay taxes at regular rates. All of a sudden, some people are suggesting that hedge fund managers might make their entity an S-Corp, so they could get the one-year provision instead of the three-year provision.
It should be obvious to anyone that the law would be implemented as applying to non flow-thru entities only. It only affects the one year holding period which was raised to three. This is unimportant anyway, because most (and certainly most substantial) gains usually take more than three years to develop anyway.
Almost every article published on this subject also incorrectly states that carried interests converts ordinary income to capital gain. In fact, it simply allocates to the manager income of the same nature as earned – ordinary, dividend, short or long-term gain.
You could probably fix the law by adding a couple of words of clarification. Every tax law is subject to the Technical Corrections Act, which is page and pages of errors that get changed. Yet all of a sudden, people are writing articles about it the rule being a loophole. It’s not, and it’s nonsense. This issue should not be getting any serious attention.