Carried Interest…now Codified? (Feb. 21)

Update 250– Carried Interest … now Codified?
In a Series of Tax Cut Act Surprises and Ironies
After everyone from Bernie Sanders to Jeb Bush to Hillary Clinton to Donald Trump campaigned to inter the carried interest loophole at long last, a funny thing happened to this decades-old but anomalous tax practice in the 2017 Trump tax cut: it was codified.

Our story involves a kind of reverse transfer payment to hedge and private equity fund managers from middle class taxpayers, over $2 billion a year. A closer look below.  

Best,

Dana

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Codified Carried Interest?

As is known, capital gains have long been taxed at much lower rates than wages and fee income. Partners in partnerships have long been taxed at capital gains rates when the partnership sells a capital asset.  The combination of these two tax rules has led to “carried interests,’ whereby a money manager receives a partnership interest in a fund in exchange for money management services, and benefits from reduced capital gains rates on their share of gains whenever the fund sells a capital asset.

A money manager who structures compensation as a carried interest – rather than a fee – benefits from a lower rate of taxation. In recent decades, this “carried interest loophole” has drawn the ire of many Democrats and some Republicans.

President Obama proposed closing the loophole, as did then-candidate Trump who claimed that fund managers were “getting away with murder.” Despite this opposition, the carried interest loophole has repeatedly survived legislative attempts to close it. The latest Republican attempt to address it comes with a particular irony — it codified the loophole it attempts to limit.

The Tax Cuts and Jobs Act purports to limit the impact of this carried interest practice by extending the asset holding period from one to three years. This means that managers can receive reduced capital gains rates when a fund sells a capital asset only if the fund has held the asset for more than three years at the time of the sale. Republicans claim this is an attempt to address an unpopular provision, but in doing so the GOP has codified a practice that previously existed only in case law and an IRS ruling.

Rushed Bill, Sloppy Drafting

Extending the required holding period for carried interest holdings is, at best, an attempt to address a loophole that costs the government billions of dollars a year. Analysts estimate that the change in the asset holding period claws back just five percent of the revenue lost from the carried interest loophole.

Worse, drafters made a major mistake including a provision that Republicans inserted into their tax bill that excuses “corporations” from the new carried interest restrictions but fails to stipulate what kind corporations are exempt. Republicans claim they meant for this provision only to apply to C-corporations that pay corporate taxes.  But the drafting imprecision means that S-corporations that are not subject to corporate taxes can also avoid the enhanced waiting period.

As a result, hedge fund managers can simply drop their interests into a new S-corporation and obtain long-term capital gains rates after a one-year holding period, rather than the three-year holding period imposed by the Tax Cuts and Jobs Act.

Retaining easy access to the carried interest loophole allows managers to pay a federal personal income tax of 23.8 percent (20 percent tax on net capital gains plus a 3.8 percent investment tax). Otherwise, managers face the ordinary top personal income bracket which sits at 37 percent. Unsurprisingly, fund managers are jumping to take advantage of the loophole.

S-Corp Shell Games

Hedge funds are now creating scores of new shell companies to continue to take advantage of the carried interest loophole. Delaware is the epicenter of this process and is once again seeing an influx of hedge funds, with some of the biggest names in the business world involved.

What Can Be Done?

Last week, Sen. Wyden, ranking member of Senate Finance, blasted the new loophole, calling the two year extension for carried interest qualification “a farce.”  In response, Treasury Secretary Mnuchin claimed to have already met with the IRS and Office of Tax Policy on the topic, and promised to have the loophole closed within the next couple of weeks.

In spite of such promises, it is not entirely clear what authority the Treasury has to close the loophole. The Treasury and IRS have broad authority to interpret tax laws, but they cannot contravene or change them. While Secy. Mnuchin was quick to claim the authority to fix the mistake, industry representatives have already signalled a willingness to fight any attempts to limit the ability of S-corporations to claim the carried interest exemption. Expect any moves from Treasury to be challenged in court and for fund managers to continue re-incorporation all the while.

Resolving this loophole through what could be multi-year litigation will certainly be an unacceptable timeframe for those like Sen. Wyden who are furious about the loophole. After having been rushed through Congress by Republican lawmakers, the legislation is riddled with errors and workarounds, the extent to which is still being teased out by tax experts.

The carried interest glitch represents one of the Tax Cuts and Jobs Act’s many major technical oversights. While it is possible this mistake will only require a simple fix, it is also possible that the carried interest loophole and other fixes will require a larger fight — one that might have to wait until after the midterms.  

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The Progressive Post

Throughout the week, the 20/20 team curates a collection of relevant news clips as we research these updates. If you want to read along, today’s news digest can be found here.

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