Carried interest lives on despite tax reform

The fate of carried interest before and after 2017's tax reform drama is emblematic of the process overall: a rush to produce something regardless of whether there was true change, or in some cases, accuracy, experts said.

"The new carried interest rule was drafted to give the appearance of closing a loophole without actually doing anything. It's so riddled with loopholes that to try to fix anything is meaningless," said Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center in Washington. "Congress felt obliged to do something about carried interest — and still they haven't closed it."

Carried interest is the portion of an investment fund's returns eligible for a capital gains tax rate of 23.8% instead of the ordinary income tax rate up to 37%.

Following campaign promises by President Donald Trump that he would do away with it, carried interest was one of the lightning rods during the tax reform debate. Yet instead of an outright repeal, the final outcome required that a fund's general partners hold the relevant investments for three years, instead of one, starting in 2018.

"The final statute was a bit of a relief for private equity and venture capital, which came out relatively unscathed," said Joe Pacello, a tax partner in BDO USA LLP's asset management group in New York. Tax experts also note that a technical mistake in the bill's wording means real estate investment firms — which were supposed to be limited to the same three years — are not affected, due to an incorrect tax code reference.

"Hedge funds, on the other hand, were significantly hurt by this because their investment horizons are typically much shorter," said Mr. Pacello. Despite that, "I don't think carried interest is going to go away or come ​ to an end."

Some private fund managers found an even bigger opportunity to keep the carried interest advantage in the tax law's exemption for corporations. That led them to quickly set up corporate structures for executives entitled to receive carried interest, before a March 15 deadline to declare that status.

"There was a flurry of activity," said Mr. Pacello of BDO.

Treasury Secretary Steven Mnuchin promised to quickly close that loophole. On March 1, his department and the IRS issued a notice clarifying that S corporations are subject to the longer holding periods and that it will soon issue regulations.

The IRS announcement fell largely on deaf ears, with some tax experts questioning its legal authority to change the new law. The March 1 notice, critics said, did not have the typical IRS legal justification for issuing a new rule.

That could shift the debate back to Congress, or set the stage for legal challenges by firms if and when the IRS pursues enforcement.

"I think this needs to be addressed through a technical correction, either in the courts or Congress," said Mr. Pacello of BDO. "The IRS and Treasury are making it clear that they are going to attack this. That notice is just a notice to the industry, although it could be years before this get resolved."

Mr. Rosenthal of the Tax Policy Center thinks the IRS exceeded its authority because the law simply refers to corporations. "It was poorly drafted. This was not normal, to cram a bill through as fast as you can without hearings. It will have to be changed legislatively. They should go back to the drawing board."

Louis Tuchman, a partner at law firm Herrick Feinstein LLP in New York who chairs the tax department, agreed the tax law "was quickly put together." He is somewhat leery of what could happen in the future if the rush by fund managers to form S corporations continues. It could hamstring firms that pursue that option if they run into other tax restrictions on S corporations that are often hard to undo.

"Easy to get in, impossible to get out," Mr. Tuchman said.

There is also the federal tax issue and sensitivity over carried interest in general. "It's hard to defend the loophole for an S corporation from a policy point of view, and therefore I would expect it to be fixed," Mr. Tuchman said.

In the meantime, Democrats are hoping to keep the spotlight on the carried interest advantage enjoyed by a select few in the highest tax brackets by appealing to Mr. Trump's desire to push an infrastructure agenda. Doing away with carried interest and other changes altogether could help pay for some projects, they said.

On March 7, Democrats unveiled their own infrastructure plan. Just closing this carried interest loophole, they said, would increase federal revenues by $12 billion over 10 years.