Dec 15, 2017 - Business

Taxing "carried interest"

The Issue

President Trump said during the campaign that he wants to raise taxes on investment profits earned by managers of hedge funds, private equity funds, venture capital funds and similar sorts of partnerships.

The Facts

Most of these funds pay their managers in two ways:

  1. An annual fee on the total amount of committed capital. It's typically around 2%, and is generally paid no matter how the investments perform.
  2. Carried interest, which usually works out to around 20% of investment profits.

So if a private equity fund generates $100 million in profits, the fund managers retain $20 million. Okay, technically it's a bit more complicated, since profit-sharing goes deal-by-deal and first subtracts paid fees, but this is the basic idea.

Fund managers pay ordinary income taxes on the management fees, but only pay much-lower capital gains rates on the carried interest (so long as the investment was held for a long enough period of time, which doesn't apply to certain short-term hedge fund plays). The outside investors pay capital gains rates on their 80% of profits (unless they are tax-exempt institutions like charities or university endowments).

Proponents of the current system argue that all of a fund's investment profits are capital gains, and it doesn't matter how the various partners agree to split the spoils. Opponents argue that carried interest in essentially a fee for service (kind of like a stock-broker or wealth manager), and that this is an unjust loophole. No one argues that the outside investors shouldn't continue to pay capital gains rates, or that fund managers should pay ordinary income on profits derived from their personal investments into the funds.

What's Next

President Trump campaigned on changing the tax treatment of carried interest, as did Hillary Clinton (and Barack Obama, for that matter). Paul Ryan, however, has not taken a public position, nor did he include a change to carried interest in his "Better Way" proposal. Expect this to become part of the upcoming debate over corporate tax reform.

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