New rules bar fund managers from tax benefit

The IRS has released regulations restricting a valuable tax break that hedge fund managers were able to claim after an error in the Republicans’ 2017 tax law.

The regulations, published Thursday, bar money managers from using business entities, known as S corporations, to take advantage of an exemption to the law’s rules for taxing carried interest.

The regulations address what some tax policy experts see as a mistake in the 2017 tax overhaul that allows hedge fund managers to exploit a loophole to avoid paying higher taxes on their investments. The Treasury Department first issued a statement in early 2018 that signaled plans to change the carried interest rules.

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 eligible for lower tax rates.

The tax law extended the amount of time that hedge funds and private equity managers had to hold their investments — to three years fromone year — to get the long-term capital gains rate of 20percent. Otherwise, theyhadto pay individual income tax rates, which now top out at 37 percent.

But the 2017 law exempted corporations from having to hold assets longer before qualifying for the preferential tax rates. Hedge funds found a way to use that exemption by setting up a series of 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. Socalled C corporations, the common structure for most publicly traded companies, aren’t subject to the three-year holding period.

Some experts questionwhether the IRShas the authoritytoput this restriction in place throughregulation, given that the tax lawdoesn’t include a limitation on the type of corporations that can access the break. A recent U.S. Court of Appeals ruling suggested the same, saying the IRS may struggle to defend the rules in future legal fights.

The carried interest regulations are a politically sensitive issue. President Donald Trump, before the 2017 tax law, vowed to end the tax break, which is popular with some business-friendly members of his party. The overhaul ultimately scaled back the benefits for carried interest, rather than repealing them entirely.

Democrats long have proposed legislation that would end the carried interest tax break. Those efforts have largely been symbolic because theDemocratic-ledHouse couldn’t get theRepublicanmajority in the Senate on board.

But the tax break could be repealed once Joe Biden becomes president becauseDemocrats now control both chambers of Congress.