Loopholes 101 – Carried Interest Loophole

Loopholes 101

Carried Interest Loophole

One Sentence Argument

The carried interest loophole is an absurd mischaracterization of income that allows about 5,000 of the richest people in America to divide (conservatively) $1.8 billion a year between themselves, for an average tax break of $300,000 a year.

Issue Breakdown

The carried interest tax loophole is the poster child for the corrupting influence of money in politics. It’s so absurd that politicians on both sides of the aisle agree that it should be closed, but it’s been kept open because of the vast sums of money spent to preserve it.

This loophole allows private equity and hedge fund managers to mischaracterize their earnings as capital gains rather than income. By claiming they are in a “partnership” with their investors, they say that their earnings should be classified as capital gains instead of income (because they’re investing their time and expertise into the firm).

This lets them cut their tax bill nearly in half by using the much lower capital gains tax rate, just 20 percent, rather than the top income tax rate of 37 percent. These fund managers are some of the wealthiest people in the world, some earning hundreds of millions of dollars a year, yet they pay a lower tax rate than their secretaries or the janitors who clean their offices.

Watch a Video on the Carried Interest Loophole:

Debunking Private Equity Arguments

The capital gains tax rate is significantly lower than the income tax rate for a reason – the government believes that by incentivizing investment and risk-taking, it will spur growth. We can argue about whether that’s actually a reasonable policy, but if we’re operating within the current law then we should follow the tax code. Fund managers invest no money of their own and take on no risk, they simply manage the investments of others. This should disqualify them from claiming their earnings as capital gains.

But, the fund managers claim, they’re investing their time and their expertise, and they earn nothing in carried interest if the fund doesn’t make money. Doesn’t that count as investment and risk, to qualify their earnings as capital gains?

It’s telling that their arguments in favor of special treatment reveal how utterly normal the private-equity compensation structure really is.

First of all,the investment of time and expertise in exchange for money is quite literally the definition of employment.

Second, it’s important to note that fund managers typically earn a set percentage of a fund’s total investments each year no matter what, which is taxed as income. If the fund makes a profit, they then take an additional percentage of that profit for themselves. That additional cut is what we call carried interest, which is taxed at the capital gains rate. If that earnings structure sounds familiar, that’s because it is. Millions of people in thousands of industries get bonuses for performance, and virtually all are taxed as income. Why should carried interest be any different?

When a car salesman earns a commission for selling cars, that’s considered income. That salesman is managing the sale of someone else’s capital investments, the dealership’s cars, but because he’s operating out of a suburban car lot instead of a high-rise in Manhattan, his earnings face the standard tax rate. It’s special treatment for a few thousand millionaires, and unlike some other loopholes that may be justified on the grounds of job creation, the carried interest loophole helps no one but the fund managers themselves.

Who’s Affected?

Keeping the loophole open doesn’t help investors, because investors don’t earn carried interest. Anyone with money invested in a private-equity fund would still pay the preferential capital gains rate on their earnings, and rightly so. Closing the loophole would only affect the fund managers’ taxes on the fees they earn. And in an industry as tightly competitive as private equity, the idea that funds would simply increase their fees to compensate is ridiculous.

There are only about 3,000 to 5,000 fund managers in the US who benefit from carried interest, but because they earn so much per year, the amount of tax revenue lost through this loophole is staggering. Split between just a few thousand fund managers, they save an estimated $1.8 to $18 billion each year.

This is an astronomical amount of money to be split between so few people, and by closing the loophole we could raise significant funds for important government programs, all from millionaires who have avoided paying the proper tax rate for decades.

Updates in The Tax Cuts and Jobs Act

The carried interest loophole is so egregious that it is one of the few tax policies that Democrats and Republicans can agree on. During his 2016 campaign Donald Trump spoke out many times in support of closing the carried interest loophole, saying the managers taking advantage of it were “getting away with murder.”

Closing the loophole should have been an easy opportunity for our leaders in Washington to show that bipartisanship and cooperation were still possible, but because of a dedicated lobbying effort on behalf of the private-equity industry, the Republican tax bill didn’t just fail to close the loophole, it actually made it worse.

Previously, the carried interest loophole existed only because of a convoluted interpretation of a piece of the tax code that was never intended by the legislators who wrote it, an interpretation that the IRS could have technically reconsidered at any time. In altering the loophole, the bill actually codified it into the tax code, giving it a specific legal grounding that it had previously lacked, by allowing a special tax break for investment managers if their clients hold assets for three years or more.

The administration claims that requiring assets to be held for three years was a huge change that basically closes the loophole, but it actually affects a small portion of carried interest income, and the fundamental unfairness is exactly the same. The vast majority of fund managers who take advantage of the carried interest loophole hold their assets for more than three years anyway, so this change is effectively worthless.

Already, only 24.3% of private equity deals in the US since 2000 would have been affected by this change, and that number is surely going to drop as funds change their behavior to account for the new law. If they’re incentivized to the tune of hundreds of millions of dollars to hold assets for another year, they’re going to hold assets for another year.

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