Sen. Kyrsten Sinema, D-Ariz., and Sen. Joe Manchin, DW.V., on Capitol Hill on Sept. 30, 2021.
Jabin Botsford | The Washington Post | Getty Images
Senate Democrats passed a historic package of climate, health and tax rules on Sunday.
But a proposed tax code change — an amendment to the so-called carried-interest rules — survived an undivided Senate due to objections from Sen. Kyrsten Sinema, D-Ariz., whose support was essential for the Inflation Reduction Act to pass evenly. The bill now goes to the House of Representatives, which is expected to pass it this week.
Many Democrats and opponents call the lower carried interest rate a loophole that allows wealthy private equity, hedge fund, and other investment managers to pay a lower tax rate than some of their employees and other American workers.
“It’s a really rich benefit for the richest Americans,” said Steve Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center. “Why would a private equity manager be able to structure their compensation around low-tax profits? That seems wrong.”
Here’s what carried interest is and why many Democrats want to change taxation.
Carried interest compensates investment managers
Carried interest is a form of compensation paid to investment managers such as private equity, hedge fund and venture capital managers.
The managers receive a share of the fund’s profits – typically 20% of the total – which is divided among them proportionately. The profit is referred to as carry interest and is also known as “carry” or “profits interest”.
Here lies the tax controversy: This money is considered a return on investment. Therefore, managers pay a maximum federal tax rate of 20% on these profits, rather than the regular federal tax rates of up to 37% that apply to compensation paid as wages or salaries.
This preferential tax rate of 20% corresponds to the “long-term capital gains” that apply to investments such as stocks, bonds, mutual funds and real estate held for more than one year.
According to Jonathan Goldstein, head of America’s private equity practice at Heidrick & Struggles, an executive search firm, carried interest accounts make up the “largest portion” of the compensation paid to managing partners of private equity funds becomes.
For example, according to Heidrick & Struggles 2021, carried interest accounts for at least 84% of total managing partner compensation on average Opinion poll. The proportion varies depending on a company’s assets under management, but differs by well over 90% for partners of larger companies.
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Expressed in US dollars, the average carried interest of managing partners according to the survey was between 10 and 102 million US dollars, again depending on the total assets under management.
While capital gains for wealthy investors are generally subject to an additional 3.8% Medicare surcharge, tax experts say not all carried interests are subject to this “net capital gains tax.” Taking this into account, taxable managers owe an aggregate top rate of 23.8% federal tax, added to the top rate of 20% for capital gains.
Wealthy investors, including Warren Buffett and Bill Ackman, have criticized the tax treatment of carried interest.
“The carried interest loophole is a blot on the tax code,” said Ackman, Pershing Square’s chief executive. wrote July 28 on Twitter.
However, other tax experts and proponents of the current tax structure believe a lower rate for carried interest is appropriate, benefiting investors and the economy. Raising taxes on fund gains would discourage managers from taking risks and reduce investment capital, they said.
“Carried interest is taxed appropriately as a capital gain and is a successful policy that incentivizes investment in the US economy,” said Noah Theran, executive vice president and managing director of the Managed Funds Association, a trade group.
Higher tax rates could also have “spillover effects” by reducing returns for investors like pension funds and other institutions, said Jennifer Acuna, a partner at KPMG and former tax advisor to the Senate Finance Committee.
“Politicians have gone back and forth for many years as to what is the correct policy for taxing carried interest,” Acuna said. “I don’t think it’s a slam dunk.”
Proposal would have reduced carried interest
A deal brokered by Senate Majority Leader Chuck Schumer, D-NY, and Sen. Joe Manchin, DW. Va. originally proposed to cut the carried interest tax credit. However, the proposal was removed from the final legislation that passed the Senate.
Most importantly, the proposal would have required fund managers to hold portfolio assets for five years — an increase from three years — to receive the preferential 20% tax rate.
Managers with holding periods of less than five years would pay “short-term” capital gains tax rates on carried interest — a top rate of 37%, the same as wages and salaries for the highest-income taxpayers.
Another proposed tweak would have effectively extended that holding period beyond five years, Rosenthal said.
That’s because the original proposal would only have started counting the five-year clock after a private equity fund had made “substantially all” of its investments — a term that’s not specifically defined, but tax professionals generally use between the ages of 70 and An estimated 80% of a fund’s investment capital is committed, Rosenthal said.
In practice, that would likely have extended the effective holding period to around seven to nine years, a policy that “had some bite,” he added.
Democrats appreciated that the proposed changes would have raised the carried-interest rules $14 billion over 10 years.