Carried Interest Loophole: A Possible Twist in the Old Debate

02-07-10 © Taylor HintonIt is an old favorite of tax reform wars: the subject of the favorable tax treatment of managing partners’ compensation as capital gains.

To review the basics: “carried interest” is the share of the profits of a partnership that is kept by the general partners by virtue of the fact that they have provided managerial services. It is critical to the dominant business models in the worlds of private equity, hedge funds, and venture cap as well.

Under U.S. tax law, carried interest is treated as a capital gain, not as ordinary income. The highest long-range capital gains rate is 20%. This is a break for the covered partners, and it became a heated campaign issue in 2012, when a former managing general partner of Bain Capital ran for President of the U.S.

Now we’re in 2014, and the attention of an attention-deficient public has moved on. “Bain” is the misspelling of the name of a Batman villain.

Someone Wants a New Pair of Shoes

As I observed here last fall, citing an SEI survey, the PE industry itself doesn’t seem to be especially concerned about the prospect of an increase in taxation on carried interest. Only 3% of managers asked named that as “the most significant challenge facing the private equity industry in the next 12-18 months.” They are much more concerned about finding quality investment opportunities, wooing investors, or hedging against geopolitical uncertainties.

So any move here would come as a real shock to those most immediately affected.

Still, the government wants revenue, and by what is now a reflex action governing heads turn to the issue of carried interest. In late February of this year Rep. Dave Camp (R-MI), the chairman of the Ways and Means Committee, introduced the Tax Reform Act of 2014. It is a long and complicated bill (the discussion draft prepared by the Ways and Means staff runs to 194 pages). Still, my own hawk-like attention fell on section 3621, “Ordinary income treatment in the case of partnership interests held in connection with performance of services,” which provides for what that title says.

According to the Joint Committee on Taxation, this provision would increase revenues by $3.1 billion over ten tax years.

The White House issued its own budget plan in March. It, too, embraced the idea of closing this loophole.

Eileen Appelbaum and Rosemary Batt made the case for closing the “loophole” in The Hill this spring. They accept the figure from JCT, rounding it down to $3 billion, and add to this a critique of the “excessive risks” that they see as endemic to the PE world, and the skewed incentives that encourage general partners to keep taking those risks.

The Real Action May Move

We may yet see the real action on this issue move to the state and eve the municipal level. Just as with higher minimum wages, gay marriage, and for that matter the legalization of marijuana – items long stalled on the federal agenda can sometimes get some play in localities.

Yes, it is easy for PE funds and other affected entities to adjust where and how they do business to try to alleviate such an effect. But they aren’t going to hide in Galt’s Gulch – that’s fiction, folks. They are going to do business somewhere.

For that matter, there is the possibility they won’t bother with much interstate arbitrage, because it will be possible to deduct what they lose at that level from their federal taxes. In that case, the ongoing dispute over carried interest will become part of a new experiment in federalism and revenue sharing, in which the federal government implicitly abandons a potential revenue scheme and allows states to pick up … at least some of it.






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