The Carried Interest Loophole

The Treasury Secretary, Steve Mnuchin, has delivered some incoherent messages about tax reform. It appears he has not yet understood that tax policy will be driven by the President working with his new Democratic friends Nancy Pelosi and Chuck Schumer. One of the tax beasts to be slain is carried interest, the pernicious mechanism by which $20bn of wealth annually is delivered to the 1% with careless regard for the suffering of the middle class. President Trump has promised to fix this. In this, he is not alone. Carried interest has been in the crosshairs for over ten years. Even the 1% broadly agree that it is without merit. But why is it still around?

Background

Carried interest originated in the maritime world. Captains would be given a profits interest in the cargo they carried. It was a way to incentivize safe passage. In the world of private equity, the general partner or sponsor of a fund typically is granted two forms of compensation: a management fee of, say, 2%; and a profits, or carried, interest of 20%, for example. This means that the limited partners who provided 100% of the capital give up 20% of the gains generated on that capital to the fund sponsor who found the deals and managed the deals that generated the profits.

Not such a bad deal for the recipients of the money. The bad press relates to the way this carried interest is taxed. The mechanism by which the carried interest is delivered is through a partnership distribution to the fund sponsor or general partner. Distributions to partners have the character for tax purposes of the gain in the partnership. If the partnership has generated a capital gain, then the distribution to its partners will be capital in character. If the partnership has held the capital investment for longer than twelve months, then that capital gain will be taxed at the rate applicable to long-term gains.

This is the problem. Long-term capital gains are taxed at approximately half the rate of short-term gains or ordinary income. Ordinary income is the kind of income a typical employee makes in exchange for their services.

Many commentators believe that, because the fund sponsors typically invest no capital in the partnership, the carried interest is actually a form of compensation for services and should, therefore, be taxed as ordinary income. It is a reasonable argument and one that many fund sponsors tacitly agree with.

The Treasury Secretary’s Approach

The Treasury Secretary has suggested another approach to the taxation of carried interest. His approach, however, does not sound well-considered. He has stated that the carried interest loophole will be denied to hedge funds but preserved for private equity funds – he describes them as “other entities that create jobs”.

It is unclear how this standard might be expressed in legislation. It is also disingenuous because hedge funds are not the largest beneficiaries of carried interest. Most of their profits are through short-term trading rather than long-term capital gain. Removing the carried interest from hedge funds is like raising the price of gas for a Tesla owner; they are indifferent.

If the tax rate on individual income were reduced to 20%, the issue would largely disappear. Partnership income is also referred to as “pass-through income” because the tax burden is passed through to the partners. Partners are typically taxed at the individual rate. Currently, the highest individual rate is 39.5%, almost double the rate at which long-term capital gains are taxed.

If the highest individual rate were lowered to 20%, the relative advantage of the long-term capital gains rate would largely disappear. Unfortunately, that would also deliver a huge windfall to the top 1% of taxpayers, something the President has promised not to do. He has argued for reducing the tax rate on corporations to 15-20%. That is not something that would impact partnerships.

What Has the United Kingdom Done?

The United States is not the only jurisdiction where the taxation of carried interest has been attacked. The Inland Revenue in the United Kingdom addressed the issue in its Summer Budget 2015.

Historically, fund sponsors – while not enjoying any differential between long-term and short-term capital gains rates – were entitled to have a percentage (the same amount as the percentage of profits to which the fund sponsors were entitled) of their limited partners’ cost basis in the assets in which the partnership invested “shifted” to them.

The effect of this was to allow the fund sponsor to offset against their taxable income a portion of the cost of the partnership investments, notwithstanding the fact that the fund sponsor had invested no capital.

The Inland Revenue specifically remedied this, both by introducing legislation to tax “disguised management fees” and by removing the base cost shifting. The legislation appears to have been received without hostility and with a calm acceptance that, finally, the party was over.

Conclusion

Re-inspection of carried interest in the United States has been a long-term project for politicians, the press and the tax bar. Reasons to delay its demise have been many.

Often, the argument has been that rewriting partnership law to remove the perceived loophole is complex – it is – and should only be carried out as part of comprehensive tax reform.

An alternative approach would be simply to allow the Treasury to issue regulations that would treat the carried interest consistent with its economic substance – an option on 20% of partnership profits. Option income is ordinary income after all.