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Hedge Funds

Mnuchin’s move to end hedge fund loophole seen facing challenge

Treasury Secretary Steven Mnuchin listens during a House Appropriations Subcommittee hearing Tuesday on the fiscal year 2019 budget in Washington.

Treasury Secretary Steven Mnuchin's plan to fix a gaping loophole for hedge funds in President Donald Trump's new tax law could face legal challenges.

Tax experts say a notice from Treasury and the IRS issued March 1 fails to give the legal basis for their power to close the loophole. Congress would need to amend the statute, accountants and lawyers said, and Treasury's attempt to do so through regulation sets the stage for a court battle by one or more hedge fund titans with a lot of money at stake.

"It's striking that they don't cite any authority" in the notice, said David Miller, a tax partner at law firm Proskauer Rose. "I'm certain someone will challenge this."

At issue are S corporations, and whether money managers can use them to circumvent new rules and avoid paying higher taxes on carried-interest income. Scores of hedge fund managers began setting up such companies in Delaware based on the wording of the law, which gives exemptions to "corporations" without noting any types. The notice said that firms will not be able to use S corporations to skirt the restrictions.

Mr. Mnuchin has said he thinks he has the power to block the maneuver. At a Feb. 14 hearing before the Senate Finance Committee, he stated that "this is something we believe we have the authority to do" because the Internal Revenue Code leaves "a certain discretion to me as secretary and the IRS."

Treasury will explain the reasoning behind its position on S corporations when the agency releases proposed regulations, a Treasury official said March 2.

Mr. Trump vowed to do away with the preferential tax treatment for carried-interest income as part of his populist campaign to capture the White House. The law that passed in December made it harder for some money managers to pay taxes on carried interest at a lower capital-gains rate by boosting the required holding period for assets to three years from one.

But the law contains such an obvious loophole that many tax experts regard the escape hatch as a drafting error by congressional Republicans. Advisers have been telling clients that the Trump administration would likely seek to fix it.

In the meantime, money managers appeared to have been moving to exploit the loophole in case it remains in place. Firms have been setting up a single-member limited liability company for each executive entitled to receive carried interest, Bloomberg reported last month. The company could elect to be treated as an S corporation, making the carried interest it received eligible for the one-year holding period at the capital gains rate of 20% rather than the ordinary income rate for compensation which tops out at 37%.

Last week's announcement on S corporations was the second time officials sought to block a potential money-saver for taxpayers in the law without saying where they got the authority, according to Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center in Washington. He said the IRS used a similar tactic to discourage homeowners who sought to prepay their 2018 property taxes in December, seeking to beat the law's cap on deductions for such taxes going forward.

"This appears to be their new approach," Mr. Rosenthal said in an interview. "Scare taxpayers without any support."