Carried Interest Loophole

Update 551 — Carried Interest Loophole:
Which is the Fairest Payfor of Them All?

The prospect for trillions of dollars in new federal spending in FY 22 and a consensus that the spending should be paid for — by taxes, not by borrowing and adding debt — put a premium on payfors, provisions to raise up to $3.5 trillion in revenue.

Among the lowest-hanging fruit on the payfor tree this year is the carried interest loophole, which has long stood out as one of the most notorious reverse wealth transfers in Code. Warren Buffett famously said, in reference to carried interest, that it allows him to “pay a lower tax rate than my secretary.”

This update will examine the carried interest loophole, the reasons for closing it, and why it’s a good bet it will be gone next tax year.

Good weekends all,

Dana

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Early Wednesday morning, the Senate passed a budget resolution setting the stage for Congress to move forward with a $3.5 trillion spending package that includes critical investments for social programs and climate infrastructure. 

Democrats plan to fund this legislation by ensuring that all corporations and high-earning individuals pay their fair share of taxes. With an enormous demand for payfors, much of the political debate is on revenue proposals. Closing the carried interest loophole would bring in $20-60 billion and has been endorsed by almost everyone from Sen. Sanders to Donald Trump. 

What is the Carried Interest Loophole?

The carried interest loophole benefits hedge funds, venture capital, real estate partnership, and private equity managers almost exclusively. Investment fund managers are compensated for their advice and management services. But under current law, fund managers are able to claim this income as capital gains, taxed at the preferential rate of 23.8 percent instead of the ordinary top tax rate of 37 percent. And fund managers are often able to defer tax payments on the profits’ interest for years, only paying when income is realized by the partnership, such as through the sale of an investment.

The carried interest loophole allows fund managers to benefit from profits made by putting other people’s money at risk as if it were their own. Doctors, school teachers, and police officers — all other service providers — pay ordinary tax rates on their labor income, the salary of hedge fund managers gets special tax treatment — a grossly unfair loophole that costs American taxpayers billions each year, while benefiting a few thousand financiers.

For more than a decade, Democrats and Republicans have ridiculed the carried interest loophole as a blatant handout to some of the wealthiest earners. In 2007 and 2008, the House passed legislation ending the loophole, but both times it died in the Senate after intense lobbying efforts by the private equity industry. During the 2016 election, Donald Trump and Hillary Clinton both campaigned aggressively on fully closing the carried interest loophole. However, in the subsequent 2017 Tax Cuts and Jobs Act, Republicans only made a minor change to the law by lengthening the asset holding time before the preferential tax treatment would kick in from one to three years.

Active Carried Interest Legislation

President Biden has called for carried interest to once again be put on the chopping block to partially offset the cost of his Build Back Better agenda. While there is broad support in Congress for closing the carried interest loophole, there are differences in opinion when it comes to the specifics. Below we outline the two most prominent legislative proposals.

  • Carried Interest Fairness Act (Baldwin/Pascrell): This bill would subject income from carried interest (defined as an “investment services partnership interest”) to ordinary tax rates and self-employment taxes. The bill also turns off the Section 1202 tax benefit for fund managers and ends the rule that assets can be distributed “in-kind” without triggering gain or loss for holders of carried interest. The bill would also increase the penalty for carried interest tax evasion to ensure greater compliance. This legislation has a diverse backing within the Democratic caucus (including Sen. Joe Manchin) and is viewed as the closest of the two bills to Biden’s “green book” proposal. If passed, the CIFA is estimated to generate $15 billion in new revenue over the next ten years. 
  • Ending Carried Interest Loophole Act (Wyden/Whitehouse): Last week, Senate Finance Chairman Ron Wyden introduced his own carried interest proposal. While sharing many characteristics with the CIFA, Wyden’s bill goes a step further by ending the tax deferment period for carried interest and replacing it with a quasi mark-to-market formula to assess the annualized value of “deemed compensation.” The legislation ties the annualized value to the par yield for five-year High Quality Market corporate bonds (currently sitting at 1.22 percent) plus an additional nine percentage points. If passed, the ECILA is estimated to generate $63 billion over the next ten years.

Next Steps and Political Feasibility 

The upcoming reconciliation package is the most viable legislative vehicle to end this loophole once and for all. We expect the reconciliation mark-up process to begin in the House during the first week of September, with the Ways and Means Committee having jurisdiction over all tax-related policies. While no guarantee of final success, getting carried interest reform into the Ways and Means mark-up is the first and most critical step to ensure that it ends up on the President’s desk. As of this writing, six Ways and Means Committee Democrats are co-sponsoring the CIFA, with four more members who sponsored past iterations of the bill, including Ways and Means Chairman Richard Neal, who did so in 2007.

The budget resolution sets September 15 as the soft target date for all committees to hand in their homework. Senate Democrats are possibly planning to circumvent their committee mark-up process altogether and instead put forward a manager’s amendment to the House passed omnibus bill. Either way, anticipate Wyden to push for the ECILA to be included in the Finance Committee’s portion of the package. 

We expect the private equity and hedge fund industries to fight tooth and nail to protect their special interest tax break. Already word has leaked they are hiring an army of lobbyists and making big media buys to keep members of Congress from enacting tax equity. Their efforts are pushing against the headwinds of public opinion, which is strongly in favor of reining in excessive Wall Street profit. Polling shows that 68 percent of voters and 81 percent of small businesses support closing the carried interest loophole for fund managers. 

This is the Year it Gets Done

With two legislative proposals gaining traction to close the carried interest loophole, it’s clear the appetite among Democrats to end this provision is as strong as ever. While the Pascrell/Baldwin and the Wyden bills have their own pros and cons, either would end this transfer of wealth toward fund managers. With enormous demands for new revenues in the upcoming reconciliation bill, the public needs to rally behind and encourage the House Ways and Means Committee and Senate Finance Committee to end the carried interest loophole in order to fund President Biden’s Build Back Better agenda and eradicate this tax giveaway once and for all. 

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