Podcast: Disputing Tax: What is a Corporation? Charleston Area Medical Center and the New Carried Interest Regulations
In this episode of Ropes & Gray’s podcast series, Disputing Tax, Ellen Gilley, an associate in the tax controversy group, is joined by Kat Gregor, a tax partner and tax controversy group co-founder, and Brittany Cvetanovich, an associate in the tax group, to discuss a recent Federal Circuit case, Charleston Area Medical Center, Inc. v. United States, and the interaction between that case and the brand-new proposed regulations on the so-called “three-year carried interest” rule in section 1061 of the Code.
Ellen Gilley: Hello, and thanks for joining us today on Disputing Tax, a Ropes & Gray podcast series focused on tax controversy-related matters and developments. I’m Ellen Gilley, an associate in the tax controversy group. Joining me today are Kat Gregor, a tax partner and tax controversy group co-founder, and Brittany Cvetanovich, an associate in the tax group. In today’s podcast, we are going to discuss a recent Federal Circuit case, Charleston Area Medical Center, Inc. v. United States,1 and the interaction between that case and the brand-new proposed regulations on the so-called “three-year carried interest” rule in section 1061 of the Code. In the Charleston Area Medical Center case, the Federal Circuit held that nonprofit entities incorporated under state law are “corporations” for purposes of determining the rate of interest the IRS must pay on tax refunds under section 6621(a)(1). Just as interesting as the holding, however, was dicta regarding the scope and meaning of the term “corporation” in other contexts. But before we get there, let’s briefly review the facts of the case. Kat, could you provide some background?
Kat Gregor: Sure, thanks, Elle. In the Charleston Area Medical Center case, it was undisputed that the two taxpayers, both of which were tax-exempt organizations under section 501(c)(3), were entitled to a refund. Although tax-exempt organizations are generally exempt from federal income tax, they are not exempt from taxes on wages from employment under the Federal Insurance Contributions Act, or “FICA.” The taxpayers paid FICA tax on medical residents’ wages between 1995 and 2005, and became entitled to refunds when the IRS made an administrative determination, applicable retroactively, that medical residents fell within an exception to the definition of employment under FICA.
At issue in the case was the proper amount of the refund. Section 6621 of the Internal Revenue Code governs the interest rate taxpayers receive when they overpay their taxes and provides that corporations are entitled to lower interest rates than other taxpayers – generally around 2.5 percentage points less. So here, the two taxpayers argued that as tax-exempt, 501(c)(3) entities, they should not be considered “corporations” for purposes of section 6621.
Ellen Gilley: Have there been any other similar cases addressing this issue?
Kat Gregor: Yes, prior to the Charleston Area Medical Center case, similar cases had been brought in the Second, Sixth, Seventh and Tenth Circuits. In all of these cases, nonprofit entities argued that they should not be considered “corporations” for purposes of section 6621.
Ellen Gilley: It seems like that would be a difficult argument to make, particularly for entities incorporated as nonprofit corporations under state law, which was the case for both of the taxpayers in the Charleston Area Medical Center case. Brittany, how did those taxpayers argue their case?
Brittany Cvetanovich: They argued that the statutory language of another subsection of section 6621 implied that only C corporations should be treated as “corporations” entitled to a lower interest rate on tax refunds. They also noted that the Code-wide definition of a corporation given in section 7701(a)(3) provides examples of corporations, and does not list nonprofit entities. The taxpayers also found support in old regulations that governed entity classification before the check-the-box rules were effective.
Finally, the taxpayers found support for their position in Treasury Notice 2018-18, which provided interim guidance on section 1061 of the Code. Section 1061, very generally, provides that a recipient of carried interest, such as that paid to sponsors of private investment funds, is not eligible for preferential capital gain rates on carried interest income unless the gain was derived from assets held more than three years. The rule doesn’t apply to any partnership interest held by a “corporation,” but it is not clear on the face of the statute whether this reference to corporations includes both S corporations and C corporations. Notice 2018-18 announced that the Treasury Department and IRS intended to issue regulations clarifying that the term “corporation,” as used in 1061, refers only to C corporations and not to S corporations. The taxpayers in Charleston Area Medical Center used this Notice to argue that the term “corporation” should be narrowly construed as a reference to C corporations rather than all corporations generally.
Ellen Gilley: Did the taxpayers prevail on any of these arguments in the Charleston Area Medical Center case?
Brittany Cvetanovich: No, the court agreed with the government that section 6621 used the term “corporation” generally, and thus 501(c)(3) entities incorporated under state law should be considered corporations under the statute. Accordingly, the taxpayers were only entitled to the lower rate of interest given for overpayments by corporations.
The court thought the taxpayers’ textual arguments were weak, because the provisions they pointed to were either not clearly meant to be exclusive, or they addressed a completely different situation, in the case of the entity classification regulations.
The court also explained that, under the common law, the term “corporation” is generally construed broadly. The court said, “there can be no doubt that the historical common law understanding of ‘corporation’ extended to nonprofit entities such as the Taxpayers at issue here.” As an example, it cited the 1819 Supreme Court case Trustees of Dartmouth College v. Woodward,2 which held that Dartmouth College was a corporation. In that case, the Supreme Court stated that a corporation, “being the mere creature of law, possesses only those properties which the charter of its creation confers upon it, either expressly, or as incidental to its very existence.”
Cases in this area generally hold that if an entity is incorporated under state law, the entity should be considered a “corporation” under the Code unless the statute itself indicates otherwise. This is true whether the entity is a C corporation, an S corporation, or an incorporated nonprofit entity. For example, in O’Neil v. US,3 the court referred to incorporation under state law as the “definitional lodestar” of a corporation under the Code and stated, “all organizations bearing the label ‘corporation’ under state law” are “accorded that status for federal income tax purposes.”
Ellen Gilley: Given this precedent, was the outcome in the Charleston Area Medical Center case unexpected?
Brittany Cvetanovich: No, this outcome was not surprising. This was the fifth case on this question, and all the prior cases had similarly held that nonprofit, tax-exempt corporations are corporations for purposes of this section of the Code.
Ellen Gilley: So, if this issue had been addressed previously, Kat, why was the Charleston Area Medical Center case noteworthy?
Kat Gregor: Well, what’s new in the Charleston Area Medical Center case is what the Federal Circuit said about section 1061.
Again, Notice 2018-18 said that when section 1061 exempts “corporations” from the three-year carried interest rules, “corporations” means only “C corporations,” not “S corporations.” C corporations pay tax at the corporate rate on all of their income, whether it’s capital gain or ordinary income, so the Notice seems to have taken the position that Congress only intended to save C corporations the administrative burden of determining whether or not the three-year rule applied when it would not actually make any difference in the tax rate paid. S corporations, by contrast, are flow-through vehicles, and their shareholders are taxed at different rates on the capital gain and ordinary income earned by the S corporation. So the Notice took the position that the three-year carried interest rule applies to all interest holders in flow-through vehicles, including S corporation shareholders, and that only C corporations are covered by the exemption for corporations.
Ellen Gilley: So, to confirm, for purposes of section 1061, the term “corporation” means C corporations, but in section 6621, the term “corporation” means all corporations?
Kat Gregor: Yes, that appears to be the government’s position.
In the Charleston Area Medical Center case, the government argued that the term “corporation” is generally used broadly throughout the Code, and that this broad interpretation meshes with the historical common law understanding of the term.
But then in Notice 2018-18, the government takes the position that, under section 1061 specifically, the term “corporation” does not mean corporations generally, but rather only those treated as C corporations for federal tax purposes.
Ellen Gilley: It looks like Brittany might be disturbed by some inconsistency in the government’s two positions.
Brittany Cvetanovich: I am!
There is definitely a tension and inconsistency between these two positions, and in the Charleston Area Medical Center case, the Federal Circuit acknowledged as much. The court actually questioned the authority of the IRS and Treasury to define “corporation” under section 1061 as applying only to C corporations. Here is a quote from the case: “While we question whether the regulations described in the Notice, if codified, would be proper in view of the government’s position in this case that the Code incorporates the broad, common law meaning of ‘corporation,’ we leave that issue for another day. Indeed, the Notice is just that – a Notice regarding regulations that do not yet, and may never, exist.”
Ellen Gilley: Kat, but didn’t the 1061 proposed regulations just come out?
Kat Gregor: Yes, the long-anticipated proposed regulations on section 1061 were just released on July 31. As we noted earlier, 1061 generally provides that a recipient of carried interest is not eligible for preferential capital gain rates on carried interest income unless the gain was derived from assets held more than three years. Section 1061 works by identifying a partnership interest held in connection with the performance of certain specified investment management services as an “applicable partnership interest” or “API.” For holders of an API, gain that would be otherwise characterized as long-term capital gain will instead be characterized as short-term unless the asset generating the gain has been held for more than three years. The statute contains an exception to this general rule that states “any interest in a partnership directly or indirectly held by a corporation” cannot be an API. So defining what is a “corporation” under the statute is very significant, as “corporations” can hold partnership interests that would otherwise be APIs without having any long-term capital gain be recharacterized as short-term capital gain.
Ellen Gilley: Thanks for clarifying. So under the proposed regulations, are S corporations considered “corporations” for purposes of section 1061?
Kat Gregor: No, they are not. Along the same lines as Notice 2018-18, the proposed regulations state that S corporations should not be considered “corporations” for purposes of section 1061. The proposed regulations take the position that any entity treated as a pass-through for tax purposes, meaning that the entity’s owners are taxed each year on the entity’s income, should be subject to the section 1061 rules. In addition to S corporations, this category of pass-through entities also picks up “passive foreign investment companies” or “PFICs” if the shareholders have already made something called a “QEF election” to be taxed annually on their pro rata portion of the company’s income.
In other words, the IRS is taking the position that if the entity is functionally a pass-through for tax purposes, it’s not a corporation for section 1061 purposes.
Ellen Gilley: But this seems like a pretty broad carve-out to the definition of corporation. Although S corporations and PFICs that have made a QEF election may share some common features with pass-through entities, it seems like they would generally be considered “corporations” on the reasoning the court applied in the Charleston Area Medical Center case. Did the proposed regulations try to justify this approach, especially given the court’s dicta in that case?
Brittany Cvetanovich: The proposed regulations do attempt to address the court’s dicta, though without directly referring to it. Section 1061(f) instructs the IRS and Treasury to issue whatever regulations or other guidance is necessary or appropriate to carry out the purposes of section 1061. The proposed regulations latched onto this language, as well as some language in the legislative history, to argue that the IRS and Treasury have been granted broad discretion to create regulations to curb abuse, and that the rule excluding S corporations and some PFICs from the exception for corporations is necessary to prevent abuse.
Ellen Gilley: How much deference might the courts give to these new regulations? Is the matter now more or less settled?
Kat Gregor: Not exactly. Assuming the final regulations keep the same substantive rules as the proposed regulations, the first question for any court will be, “Was the statute ambiguous?” If the statute is ambiguous, then under the Supreme Court’s Chevron standard, a court must generally defer to the IRS and Treasury’s interpretation of the statute so long as it is reasonable. The interesting question here is probably whether the statute is ambiguous, because if it’s not ambiguous, the regulations cannot contradict the plain meaning of the statute.
Section 1061 states that “any interest in a partnership directly or indirectly held by a corporation” is not treated as an applicable partnership interest. If a court decides that the reference to “a corporation” unambiguously means the common law idea of what constitutes a corporation, similar to the reasoning in Charleston Area Medical Center, then there would be no room for a regulation that interprets “a corporation” to mean only entities taxed at the entity level, because that is narrower than the common law understanding. The regulation could be struck down on this line of reasoning. But if a court decides it is ambiguous whether Congress meant a corporation under the common law standard, or instead an entity taxed at the entity level like a C corporation, then the court would move on to the next step of the analysis, which is to ask whether the IRS and Treasury’s interpretation of that ambiguity is reasonable.
Brittany Cvetanovich: At that point, the IRS could point to some legislative history indicating that the term corporation was not meant to include an S corporation.4 It might also help the government’s case to point out that allowing S corporations and PFICs with QEF elections to be treated as corporations here would allow taxpayers to make an end-run around the purported purpose of section 1061, which is to subject carried interests to more onerous taxation. I think a taxpayer would have a pretty high hurdle to clear in trying to convince a court that the regulation is unreasonable, if the court agrees with the government at the first step that the statute itself is ambiguous.
Kat Gregor: So, as is often the case with Chevron questions, the taxpayer’s best case is that the statute is unambiguous and can only be interpreted in the taxpayer’s favor. The Charleston Area Medical Center case could provide some support to that argument given its reasoning that when the tax law uses the word “corporation” without further elaboration, it generally carries with it a broad, common law meaning that would generally include S corporations and PFICs.
Ellen Gilley: It will be interesting to see where all this goes. Unfortunately, that’s all the time we have for today. Kat, Brittany, I want to thank you for sharing these insights. Please visit the Tax Controversy Newsletter webpage at www.disputingtax.com, or, of course, www.ropesgray.com for additional news and commentary about other important tax developments as they arise. If we can help you to navigate this complex and rapidly developing area of the law, please do not hesitate to contact us. You can also subscribe to our Disputing Tax podcast series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
- Charleston Area Medical Center, Inc. v. United States, No. 2018-2226 (Fed Cir., Oct. 17, 2019).
- Trustees of Dartmouth College v. Woodward, 17 U.S. 518 (1819).
- O’Neil v. US, 410 F.2d 888 (6th Cir. 1969).
- See Joint Committee on Taxation, General Explanation of Public Law 115-97, JCS-1-18 (2017). back to top