Mnuchin says IRS to ban hedge fund tax dodge on carried interest

Treasury Secretary Steven Mnuchin said the IRS plans on closing a loophole that hedge fund managers had been trying to exploit to avoid paying higher taxes on carried-interest profits.

Mr. Mnuchin told the Senate Finance Committee that a Bloomberg News story Wednesday, which detailed how hedge funds created scores of shell companies to work around the new carried-profit rules, prompted him to instruct administration officials to issue guidance on the subject within two weeks.

"I've already met with the IRS and our Office of Tax Policy this morning as a result of that article," Mr. Mnuchin told the committee. "Taxpayers will not be able to get that loophole."

The new guidance would effectively kill hedge fund managers' plans to create numerous shell companies in Delaware — corporate America's favorite tax jurisdiction — to get around the tax law's requirement that assets must be held for three years instead of one year to qualify for a lower tax rate.

Carried interest is the portion of an investment fund's returns that are paid to hedge fund managers, private equity, venture capital and certain real estate investors. For federal tax purposes, it's eligible for a tax rate of 23.8% — which includes a 3.8% tax on investment income imposed by the Affordable Care Act — on sales of assets held for at least three years. Otherwise, it's treated as ordinary income and managers face a top federal income tax rate of 37%.

Big names appeared to be embracing the maneuver, which requires setting up LLCs for managers entitled to share carried-interest payouts. Four LLCs have been created under the name of Elliott Management Corp., the hedge fund giant run by Paul Singer. More than 70 have been established under the names of executives at Starwood Capital Group Management, the private equity shop headed by Barry Sternlicht.

President Donald Trump turned carried interest into a rallying cry during his populist presidential campaign, declaring that "hedge fund guys are getting away with murder." Critics from billionaire Warren Buffett on down essentially agree, saying carried interest is a fee-for-service and should be taxed at the individual rate. But money managers have successfully argued for years that carried interest is a capital gain.

Under pressure from industry lobbyists and exploiting a split among White House advisers, the Republican Congress in December failed to fulfill Mr. Trump's promise to end the tax windfall enjoyed by money managers. And lawmakers seemed to stumble in trying to narrow their tax advantage, writing the new carried-interest rule in a way that provided firms an easy escape.

Mr. Mnuchin's comments were in response to questions from Sen. Ron Wyden, the top Democrat on the committee, who called the longer holding period for carried interest a "farce" given the hedge fund workarounds.

But the Treasury secretary pushed back on Mr. Wyden's comment that the legislation needed a fix, insisting that the IRS had the authority to resolve the issue through guidance.

There was ambiguity because the rule exempts carried interest from the longer holding period when it's paid to a corporation rather than an individual. But to the surprise of legal and accounting experts, the law didn't specify that it applied solely to regular corporations, whose income is subject to double taxation.

Hedge funds had been preparing to exploit the wording: Managers were betting that by simply putting their carried interest in a single-member LLC — and then electing to have it treated as an S corporation — the profit would qualify for the exemption from the three-year holding period and be taxed at the lower rate. The maneuver by money managers contributed to a 19% jump in the number of LLCs incorporated during December in Delaware.

Many hedge funds set up the LLCs as a first step, and were waiting to see whether the federal government would issue additional guidance. They had until mid-March to decide whether they would elect to have the LLCs treated as an S corporation for tax purposes.

If the IRS issues guidance knocking down the tactic, hedge fund managers can simply leave the single-member LLCs as is, and the vehicles would have no impact on their taxes, said David Untracht, a principal at Untracht Early, an accounting firm that advises alternative asset managers on tax issues.

"Most of us thought it wouldn't work," Mr. Untracht said. "But nobody wanted to be the only one on the Street not to be in a position to take advantage of it" if it did work, he said.

The Delaware filings "spiked through the roof because all these fund managers set up single-member LLCs," said Anthony Tuths, a tax principal in the alternative investment unit of KPMG's New York office. Mr. Tuths had said prior to Mr. Mnuchin's comments on Wednesday that he didn't endorse the strategy because the government could still close the loophole.

Spokesmen for the firms declined to comment or didn't return a request for an interview on the purpose of the LLCs.

Hedge funds that set up thousands of LLCs are difficult to identify. Some include the names or initials of executives at activist hedge funds Corvex Management and Sachem Head Capital Management, Delaware records show. Steadfast Capital Management, Permian Investment Partners and Stelliam Investment Management also created LLCs.

Hedge funds that follow activist, credit and distressed strategies, which sometimes keep investments for one or two years, are particularly affected by the new three-year holding requirement.

Private equity firms also formed LLCs in late December, even though their typical five-year holding period means the new law may not be an issue for many of them. Crestview Capital Partners incorporated 28 LLCs in the last month of the year.