History of the Carried Interest Loophole
The term carried interest goes back to the medieval merchants in Genoa, Pisa, Florence, and Venice. These traders carried cargo on their ships belonging to other people and earned 20 percent of the ultimate profits on the “carried” product. At the time, this made sense as the shipmen would risk everything to see the journey through.1 Today, venture capitalists compensate themselves with 20% of the profits from their funds and this is called “carry” or “carried interest”. For more than 50 years this has been a U.S law centered around the idea that putting up a building, starting a small business or investing in company stock carries risk, and that entrepreneurs should be rewarded when they sell something they helped build through early vision and money as opposed to someone who bought and sold quickly, and didn’t take the risk of a start-up.2
Basic Definitions
1) Capital Gains Rate: When you pay your income taxes, you pay a certain percentage of your income. Your income is all of the wages and salary you received during the year, plus other things such as investment income and profits that you received. If you sell some investment that you previously bought at a lower price, the difference (your profit) is part of your taxable income. Different types of income are subject to more-or-less taxes. Specifically, if you held the investment for more than one year, that part of your income is subject to a different tax rate (known as the capital gains rate) that other income (generally a tax rate of only 15%).
2) Characterization of partnership income: If you are a partner in a partnership, you pay taxes on your share of the partnership income, exactly as if you earned that particular income personally. If that partnership earned interest on an investment, you pay taxes on your share of the interest on the investment, if the partnership had a capital gain; you pay taxes on your share of that capital gain, at the lower capital gains rate.
3) Investment Partnerships: For investment partnerships (often called “hedge funds”) typically the investor’s share of the income is their pro-rata share (based on how much they invested) times 80%. The other 20% is the share of the partner who is the manager. It is called the incentive fee (or “carried interest”) because in theory getting 20% of all of the profits incentivizes the manager to try to make a lot of profits for the investors. This means that the more profits the fund makes, the more income the manager makes. All taxed at the lower capital gains rate.
Results
There is no actual section of the internal revenue code which says “investment fund managers pay lower taxes.” It is a consequence of the interaction of the points I listed above, so changing it is not a matter of just removing one rule, it is a matter of carefully crafting new rules to limit the interaction of the existing rules to only extend the benefits of the lower capital gains rates to people who actually invest capital.
If the investment partnership (which could be a hedge fund, a private equity fund, a real estate investment fund, etc.) makes money which are long term capital gains on investments held for more than one year (see (1) above) the manager pays income taxes on his income at a rate of only 15%, which is a much lower rate than other people pay taxes. This is considered unfair, because the reason for the lower rates on long-term capital gains is to encourage people to invest money; the manager is getting the benefits of those rates without investing his money.
When it comes down to it, I used to be in the money management business and in my view, the only reason why people who manage money have a lower tax rate than people who actually work for a living is that investment fund managers are more active at making political donations.
The Argument for Reform
Please read the arguments from government officials, investors, editorial boards and economists HERE.
The Arguments against Reform
1) This involves so little money it is not worth spending time on.
Our Response: We don’t know how much money would be raised by changing this (estimates vary), but the principle is the same whether it is $10 billion or $100 billion.
2) This would be a disincentive to being an investment fund manager.
Our Response: We don’t believe that a shortage of investment fund managers is a major problem in the United States today.
3) This would increase taxes for some people. Increasing taxes is bad.
Our Response: We reject the premise that increasing taxes is bad.
Our Members Sound Off
“I am in the hedge fund and private equity business and the carried interest loophole is welfare for the wealthy,” said Patriotic Millionaires Terence Meehan, Chairman of Azimuth Investment Management*
“The real mystery is how this tax break for billionaires has managed to survive all these years when everyone knows that it makes no sense for people who have no capital at risk to receive this kind of favorable tax treatment,” said Patriotic Millionaire Jeffery Gural, Chairman of Newmark Grubb Knight Frank*
“If it quacks like a duck it should be taxed like a duck!” said Patriotic Millionaire Frank Pattitucci, CEO & Owner of NuCompass Mobility*
“Closing the carried interest loophole would be a giant symbolic step toward a more economically equitable America. There is no reason for the loophole other than the political power of the financial industry. How much money do these managers make in a year? The top 25 fund managers make more money combined than all the kindergarten teachers in America,” said Patriotic Millionaire Fred Rotondaro, Chair of Catholics in Alliance for the Common Good*
“At a time when wages for working people have stagnated at 1990 levels and they are paying taxes at ordinary income rates, it is an outrage for a small group of hedge fund operators, often making hundreds of millions of dollars a year, to have their income taxed at low capital gains rates,” said Patriotic Millionaire Guy T. Saperstein, Attorney
“While I am not naive enough to think that changing the ‘carried interest’ loophole will fix all of our spending problems in Washington, eliminating it is the right thing to do,” said Stephen Prince, President & CEO of Card Marketing Services*
*Job titles are for identification purposes only
1 – http://rubicon.vc/the-term-carried-interest-goes-back-to-the-medieval-merchants-in-genoa-pisa-florence-and-venice/
2 – http://www.cnbc.com/2014/03/04/cnbc-explains-carried-interest.html