The favorable tax treatment of so-called “carried interest” that is earned by private equity managers gained a considerable amount of attention from both parties during the 2016 presidential campaign. President Trump has repeatedly called for its elimination, a goal that Treasury Secretary Mnuchin reaffirmed in remarks that he made last Friday.
This is not a new issue. In recent years, there has been a series of legislative proposals to turn off the “flow-through” character, in whole or in part, of partnership allocations of long-term capital gain in respect of carried interest and, instead, to treat all or a portion of those allocations as ordinary income. The basic policy premise is that economic profit that is in substance compensation for investment advisory services should be treated as ordinary income. There are various ways in which tax reform could address this policy goal, but implementing any such change without triggering unintended consequences or providing opportunities to circumvent the rules raises numerous complexities. In this post, we provide a very general description of the principal options that have been proposed.
Will the Taxation of Carried Interest Change? The short answer is that at this point, it is not clear. While President Trump has expressed a desire for reform, the House Blueprint is silent on the treatment of carried interest, and it is far from clear how carried interest legislation would interact with the Blueprint’s proposed special 25% tax rate for business income derived by pass-through entities or with other proposals.
As a revenue raiser, changing the treatment of carried interest may not pack a significant punch. One recent CBO analysis found that treating carried interest as ordinary income would raise only about $19.9 billion over 10 years. By contrast, the Congressional Budget Office estimates that capping the deduction for state and local taxes to 2% of adjusted gross income would raise $955.4 billion, and that repealing the LIFO inventory accounting method would raise $101.9 billion, over the same 10-year period.
It is worth noting that carried interest reform would affect a relatively small group of taxpayers. While discussions of carried interest often mention hedge funds, legislation changing the character of carried interest allocations would have little effect on many hedge fund managers because a significant portion of typical hedge fund’s income consists of ordinary income and short-term capital gains (which are subject to tax at the rates applicable to ordinary income), and many hedge funds make “mark-to-market” elections, with the result that all of their income is treated as ordinary. There may also be political pressure to provide exemptions from the application of the carried interest legislation for venture capital funds, real estate funds and infrastructure funds.
Options for Congressional Action. If lawmakers do decide to alter the taxation of carried interest, they could take one of the several different approaches that have been advanced in proposed legislation, each of which we describe in more detail below. All of these approaches raise a number of design questions that are beyond the scope of this post.
Treat All Carried Interest as Ordinary Income. One approach would be to treat the entire amount of any carried interest allocation as ordinary income. This was the approach adopted in the Obama Administration’s budget proposals, as well as Representative Sander Levin (D-MI)’s Carried Interest Fairness Act, the most recent version of which was introduced by Rep. Levin and by Senator Tammy Baldwin (D-WI) in 2015.
The Levin bill would apply to allocations made in respect of an “investment services partnership interest,” defined as any interest in an “investment partnership” acquired or held by any person (e.g., the general partner and, indirectly, its equity holders) in connection with the conduct by such person (or any person related to such person) of a trade or business that primarily involves the performance of advisory or management services with respect to assets held, directly or indirectly, by the investment partnership. Under the Levin bill, a partnership is an “investment partnership” if, at the end of any two consecutive calendar quarters: (i) substantially all of its assets (determined without regard to certain intangible assets, including goodwill or enterprise value) consist of securities, real estate held for rental or investment, interests in partnerships, commodities, cash or cash equivalents, or options or other derivatives with respect to any of these types of assets and (ii) 25% or more of its capital is attributable to passive investors (that is, partners that do not hold their interests in the partnership in connection with a trade or business).
Treat Only a Portion of Carried Interest as Ordinary Income. Other carried interest proposals would treat a portion, but not all, of the profits allocated in respect of a carried interest as ordinary income. A bill passed by the House in May 2010 would have treated as ordinary 75% (or for taxable years beginning before 2012, 50%) of the net income allocated to an individual in respect of carried interest. Under a similar bill introduced in the Senate, the applicable percentage would generally have been 75%, but would have been reduced to 50% in the case of net income attributable to the disposition of any asset held by the fund for at least five years.
The United Kingdom recently adopted its own version of this approach, generally taxing “income-based carried interest” as ordinary income (at a maximum rate of 47%), but with a lower 28% capital gains rate potentially available for carried interest arising from the performance of fund assets to the extent that they have been held, on average, for more than 40 months. This 28% rate is higher than the 20% rate generally applied to capital gains in the United Kingdom.
The “Non-Recourse Loan” Approach. Senator Dave Camp (D-MI)’s 2014 discussion draft contained yet another approach to the treatment of a portion of carried interest as compensation income. As some scholars have observed, a carried interest is economically similar to an arrangement in which the limited partners make an interest-free, non-recourse loan to the general partner of the amount of capital that generates the profits allocable to the general partner in respect of the carried interest (e.g., 20% of the limited partners’ invested capital) and the general partner invests the borrowed amounts in the fund. If the carried interest arrangement is viewed in this matter, the compensation to the general partner is the absence of an interest charge on the loan. Below-market loans between an employer and an employee are already addressed in Section 7872 of the Internal Revenue Code: the foregone interest on such “below-market loan” triggers income, and a corresponding interest deduction (subject to generally applicable limitations), for the borrower in the year in which the interest would have been payable.
The Camp proposal adopts the interest-free, non-recourse loan construct in substance, but with different consequences from those adopted in Section 7872 (and without using the terms “loan” or “foregone interest”). Unlike Section 7872, the Camp proposal does not provide for annual inclusions of deemed compensation income or deductions for deemed interest expense, but instead would change the character of a portion of carried interest allocations to ordinary income. In general terms, the Camp proposal would essentially determine an amount of foregone interest on the hypothetical loan and, if the carried interest allocations consisted entirely of long-term capital gain, would recharacterize those allocations as ordinary income in a cumulative amount equal to the cumulative foregone interest. If the carried interest allocation for any year included net income other than long-term capital gain, the foregone interest amount for that year would be reduced by the amount of such other net income, with the result that a smaller amount of long-term capital gain allocations would eventually be recharacterized as ordinary income.
State Level Actions. The lack of action on the federal level recently led the New York and New Jersey legislatures to propose their own carried interest legislation. Similar bills introduced in each state in 2016 would treat carried interest allocations as compensation income and would subject this income to a 19% surtax (or “carried interest fairness fee”), generally intended to account for the difference between the maximum federal rates on long-term capital gain (20%) and ordinary income (39.6%) recognized by individuals. New York estimated that the tax would raise roughly $3.7 billion a year for the state. The proposal is somewhat of a risky move for states with a high concentration of investment managers. Presumably for this reason, each bill provides that it will be effective only if similar legislation is adopted in each of New York, New Jersey, Connecticut and Massachusetts.