What carried interest is, and how it benefits high-income taxpayers

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Sen. Kyrsten Sinema, D-Ariz., and Sen. Joe Manchin, D-W.V., on Capitol Hill on Sept. 30, 2021.

Jabin Botsford | The Washington Post | Getty Images

Senate Democrats passed a historic package of climate, healthcare and tax provisions on Sunday.

But one proposed tweak to the tax code — a modification of so-called carried interest rules — didn’t survive due to objections from Sen. Kyrsten Sinema, D-Ariz., whose support was essential to pass the Inflation Reduction Act in an evenly divided Senate. The bill now heads to the House, which is expected to pass it this week.

Many Democrats and opponents refer to the lower tax rate on carried interest as a loophole that allows wealthy private equity, hedge fund and other investment managers to pay a lower tax rate than some of their employees and other American workers.

“It’s a real rich benefit for the wealthiest of Americans,” said Steve Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center. “Why should a private-equity manager be able to structure his or her compensation with low-taxed gains? That seems wrong.”

Here’s what carried interest is, and why many Democrats want to change how it’s taxed.

Carried interest compensates investment executives

Carried interest is a form of compensation paid to investment executives like private equity, hedge fund and venture capital managers.

The managers receive a share of the fund’s profits — typically 20% of the total — which is divided among them proportionally. The profit is called carried interest, and is also known as “carry” or “profits interest.”

Here’s where the tax controversy lies: That money is considered a return on investment. As such, managers pay a top 20% federal tax rate on those profits, rather than regular federal tax rates of up to 37% that apply to compensation paid as a wage or salary.

That preferential 20% tax rate is the same as “long-term capital gains,” which applies to investments like stocks, bonds, mutual funds and real estate held for more than a year.

Bulk of fund managers’ compensation is carried interest

Carried interest accounts for the “vast majority” of compensation paid to managing partners of private equity funds, according to Jonathan Goldstein, who leads the Americas private equity practice at Heidrick & Struggles, an executive search firm.

For example, carried interest accounts for at least 84% of managing partners’ total compensation, on average, according to a Heidrick & Struggles 2021 survey. The share varies, depending on a firm’s assets under management, though skews well over 90% among partners at larger firms.

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In dollar terms, managing partners’ carried interest ranged from $10 million to $102 million, on average, according to the survey, again depending on overall assets under management.

Additionally, while capital gains for wealthy investors are generally subject to an additional 3.8% Medicare surtax, not all carried interest is subject to this “net investment income tax,” according to tax experts. When it is factored in, managers that are subject to the tax would owe a 23.8% total top tax rate at the federal level, when added to the 20% top rate for capital gains.

Some say it’s a ‘stain’; others, a ‘successful policy’

Wealthy investors, including Warren Buffett and Bill Ackman, have lambasted the tax treatment of carried interest.

“The carried interest loophole is a stain on the tax code,” Ackman, the chief executive of Pershing Square, wrote July 28 on Twitter.

However, other tax experts and proponents of the current tax structure think a lower rate on carried interest is appropriate, benefiting investors and the economy. Raising taxes on fund profits would be a disincentive for managers to take risk and would reduce investment capital, they said.

“Carried interest is appropriately taxed as a capital gain and a successful policy that incentivizes investment in the U.S. economy,” according to Noah Theran, the executive vice president and managing director of the Managed Funds Association, a trade group.

Higher tax rates could also have “spillover effects” by reducing the rate of return for investors like pension funds and other institutions, said Jennifer Acuna, a partner at KPMG and former tax counsel for the Senate Finance Committee.

“The policies have been going back and forth for many years, on what is the right policy to tax carried interest,” Acuna said. “I don’t think it’s a slam dunk.”

Proposal would have curtailed carried interest





Source : CNBC