One of the most reviled loopholes in a tax code full of them is under threat again.
While the average American worker must pay the standard tax rate on their income, wealthy private equity managers and venture capitalists are able to pay a lower capital gains rate on one of their main forms of compensation. That’s made the so-called carried interest loophole a favorite target of politicians who call it part of a system rigged to benefit the rich, while exacerbating income inequality. Despite that, through the years, the private equity industry has successfully lobbied to keep the provision. Now President Joe Biden is hoping to succeed where others before him have failed by proposing to abolish the tax break.
1. What is the carried-interest loophole?
It allows private equity and venture capital managers to pay a more favorable tax rate on one of their main forms of compensation. Managers are able to pay a 20% long-term capital gains rate on their cut of the profit on the deals they make rather than get taxed at the 37% top rate for ordinary income.
2. Where does the idea come from?
The origins of carried interest date back to medieval times when Italian merchants gave ship captains a cut of the profit for carrying their goods safely across stormy seas.
3. How does it work?
Private-equity funds typically buy, revamp and grow mature companies with the goal of selling them for a hefty profit five to six years down the road. Venture-capital funds generally invest in fledgling businesses, sometimes at such an early stage that they generate little if any revenue. Managers in private equity generally make money in two ways: They typically charge investors a 2% annual management fee on assets. On top of that, they take a 20% cut of the profit on deals, usually only after a certain return threshold is met. The share of their earnings that comes out of that profit — a figure sometimes in the millions — has been taxed as capital gains, at a much lower rate than the top marginal income rate applied to wages.
4. How did that become a tax break?
Decades before the current explosion of growth in the private equity industry, the loophole came into existence. In 1954, Congress passed a law that enshrined it in the tax code with an original intent of helping employees in speculative fields such as oil and gas, according to a 2020 article in the Journal of Economics, Trade and Marketing Management.
5. What is Biden proposing?
To eliminate the carried-interest tax break altogether. It’s an idea the private equity industry is expected to fight vigorously. But the loophole could also be endangered, at least for top earners, by another Biden proposal, to raise the capital gains tax rate for households making over $1 million a year to 39.6%, the same level as his proposed top income tax rate.
6. Did Trump do anything about this?
The last time the loophole was addressed was under President Donald Trump, who before taking office had said that wealthy managers were “getting away with murder” via the tax break. The Republican tax bill passed in 2017 fell short of ending the break altogether, instead requiring fund managers to hold their underlying investments for at least three years to have the lower rate versus the prior requirement of one year. That change mainly hit hedge fund managers who generally don’t hang on to their holdings for that long.
7. What’s the argument over carried interest?
The preferred tax treatment has been long battled over by lawmakers and those in the industry. Critics argue that the tax break is just like any other fee and should be treated as such. Proponents say carried interest encourages long-term investment and have also argued that it creates jobs. Meanwhile, some in other parts of the financial world, such as JPMorgan Chase & Co.’s Jamie Dimon, favor eliminating the tax break, calling it “another example of institutional bias and favoritism toward special interest groups.”
8. What would the impact of eliminating it be?
In 2018, the Congressional Budget Office estimated that taxing carried interest as ordinary income would raise $14 billion over nearly a decade. Private equity firms’ senior deal-makers are likely to feel the most impact from any changes as they are the ones who typically earn the largest portion of the carry. As a result, firms may look to change how managers are paid, including ending so-called fee waivers, which are used to capture tax benefits by converting management fees to carry. Ending the loophole could impact recruitment in the industry, and create a more level playing field for banks and other companies trying to recruit applicants now drawn to private equity.
The Reference Shelf
- Law professor Victor Fleischer, known for a 2008 research paper that called to end the tax benefit, estimated in 2015 that eliminating it could raise $180 billion over a decade.
- The American Investment Council, private equity’s lobbying group, lays out its position on carried interest here, saying it helps drive economic growth.
- The non-partisan Tax Policy Center has an informative primer on “what is carried interest, and how is it taxed?”
- The Congressional Research Service wrote on the taxation of carried interest in a 2020 report.