Carried Interest – The Unfair Loophole

You don’t have to be a CPA to understand that the carried interest loophole is unfair to 99.99% of the American population!

As Congress prepares to review the tax code, this is not the time to remain silent and let this egregious unfairness continue for another fifty years. During the 2016 presidential campaign both Donald Trump and Hillary Clinton voiced their intention to discard the loophole. It’s time to stop this unfair practice that caters to such small portion of Americans.

Let’s make this simple up front.

Carried Interest (CI) is defined by the IRS as capital gains, which is currently taxed at a rate of 23.8%. If carried interest was treated differently, or as ordinary income, those who benefit from this loophole would see their CI income taxed at 39.6%, because they are at the highest income level of taxation. In other words, they are already rich. You can see why the American Investment Council, formerly the Private Equity Growth Council, which represents the investment managers that benefit from this loophole, lobby heavily to repeal CI law. Do the math. Their tax bill would double.

But hold on: The whole point of a reduced tax rate for capital gains was and remains to reward risking your own capital to spur innovation and stimulate the economy. Logical, right? Not so fast. You may recall that famous sardonic statement of Danny DeVito at the beginning of the film,

“Other people’s money!”

Well, that is the crux of the matter. Carried interest has been classified as capital gains even though the portion of money invested by the financial manager who claims this reduced tax rate doesn’t belong to him or her at the deal’s inception.

Typically – and we quote the Tax Foundation, which is non-partisan – carried interest affects private equity firms and hedge funds (a very small slice of the American population). These investment managers are usually paid an automatic 2% for their talent and expertise, or services, on the money invested for their clients. Should a particular investment rise in value over time, these investment managers earn an additional 20% of the increased value at sale. The other investors – their clients – who generally have invested 90% of the proceeds for the venture, earn 80% of the increased value and pay a capital gains rate on these profits because of the risk. But so do the investment managers, even though they typically only invest between 3-10% of their own money at signing. Did you get that difference? 10-17% of the total amount invested that is not their money gets taxed as capital gains. If there is no profit at all, they can simply “walk away” with 2%, according to Vic Fleischer, Co-Chief Tax Counsel for the Senate Finance Committee.

Where’s the risk?

Opponents to discarding the CI loophole will claim that this will cause unemployment to rise. But in reality, it is generally a wash, because some deals succeed and some don’t. They also try to broaden their opposition by claiming that eliminating the carried interest loophole would slow the economy and negatively impact many businesses, even small ones, that make long-term investments in capital. Again, discarding the capital gains rate for these and any investment is not under consideration. We only refer to money invested that does not belong to the investor.

We’re not debating the capital gains tax rate on the amount of personal money invested by professional investors who manage partnership-structured funds, be they private partners, hedge fund, real estate, or infrastructure managers. Our contention is that using this rate for money that does not belong to the fund managers at the start of the venture is not only unfair – it is wrong. Expertise and talent, no matter how great – and no one would claim otherwise – is a service. And every other American in this country is taxed for their services, or labor, as ordinary income. That is what carried interest is, or should be – ordinary income.

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