Rich Wall Street money managers may be able to avoid paying higher taxes thanks to an oversight in the new tax law.
A glitch in the Tax Cuts and Jobs Act appears to allow them to escape a crackdown on long-criticized tax break for “carried interest” that allows hedge funds, private equity firms and others to pay much lower rates on some of their income than ordinary wage earners.
“It’s a giant loophole,” said Libin Zhang, a tax partner at Roberts and Holland LLP.
The issue threatens to inflame Washington’s long-running war over the break, which allows fund managers to treat much of their earnings as capital gains rather than higher-taxed ordinary income. It may also put more pressure on lawmakers to address other glitches in the law.
The law doesn’t eliminate the tax break as President Trump once promised, but it does make it harder to claim by requiring to hold onto their assets longer before they can take it.
But in spelling out the details of how exactly the new rules work, lawyers say Congress inadvertently created a way to avoid them entirely.
The tax savings that could be reaped would be substantial – instead of paying ordinary rates topping out at 37 percent, someone could instead pay the 20 percent long-term capital gains rate.
In a congressional hearing Wednesday, Treasury Secretary Steven Mnuchin said his department would quash the loophole, though not everyone agrees it has the legal authority to stop it.
Democrats have railed against the break for more than a decade, saying it gives an unfair advantage to the wealthy, but have been unable to rescind it. Trump promised to kill the provision during his campaign, saying hedge fund managers were “getting away with murder.”
But Republicans writing the new law ran into a fierce lobbying campaign by the beneficiaries, and settled for extending the amount of time needed to hold assets before someone can qualify for the break to three years, from one year.
The snafu stems from the fact that the law excuses corporations from the new carried interest rules, but doesn’t stipulate which kinds of corporations – it refers to them only generally.
Lawmakers likely meant so-called C corporations like Apple, Proctor & Gamble and other big name, publicly traded companies.
But there are also what’s known as S corporations, which are another type of business organization. Lawyers say S corporations can be easily set up, and predict they will become more popular if they can now be used to duck the new carried-interest regime.
“Any hedge fund manager can just drop his or her interests into an S corporation and avoid the carried interest rules completely,” said Zhang.
It’s not clear why lawmakers included a line in the law excusing corporations from the carried interest rules, because they can’t tap the break in the first place. They must pay the newly lowered 21 percent corporate tax on all their income. It may have been an attempt to simplify corporate taxes.
Appearing before the Senate Finance Committee, Mnuchin said Treasury would issue rules in the next two weeks closing the loophole.
“We do believe that taxpayers will not be able to get that loophole by going through Subchapter S’s and that’s something we believe we have the authority to do,” he told lawmakers. “We will have that resolved.”
The agency can issue rules interpreting the law, but not contravening it.
Regulators will have a tough time addressing the loophole, Zhang predicts.
“Even if the IRS says, ‘Hey guys, nice try, but this doesn’t work,’ I think that would be tough for the IRS to necessarily win in court,” he said. “The statute is clear – it says ‘corporation,’ it doesn’t say ‘C corporation’ or ‘corporation other than an S corporation.”
“It’s not a slam dunk for the IRS to just come out and say that this doesn’t work.”