In December, when Congress passed the GOP tax bill, they didn’t close the carried interest loophole like Trump promised. In fact, they took the grey area that the loophole thrived in and made it black and white. Rather than manipulate the tax code, hedge fund managers can now point to specific language in the tax bill that allows them to pay a lower tax rate than every other American.
Originally, the carried interest loophole was an interpretation of the existing tax code that manipulated three areas of the tax code: the capital gains rate, the characterization of partnership income, and investment partnerships. In order to spur investments that carry risks, the federal government allowed investors to pay taxes at a lower rate if they held the investment for at least one year. The lower rate is known as the capital gains rate, and is now at 23.8%. If you are a partner in a partnership, you pay taxes on your share of the income, meaning if you earned interest in an investment, you would pay taxes on your share of that capital gain.
Now here’s where the loophole comes in. Hedge fund managers consider themselves part of investment partnerships called “hedge funds.” Typically, the investor gets 80% of the profits, and the manager gets 20% for successfully managing the money. This incentive goes back to medieval times, when merchants would give shipmen 20% of the profits of cargo they “carried” safely. Today, it is called an incentive fee or carried interest, and is used to encourage hedge fund managers to make a profit on investors’ money.
Okay, so how did the tax bill make this worse?
The GOP tax bill codified the loophole. As stated above, the capital gains rate is specifically for incentivizing investments, meaning it is intended to be used by those who put their money at risk for startups, company stocks, or building property. Someone who is strictly a fund manager does none of these things. She simply performs her job, just as a lawyer or janitor would. Up until last fall, it was by manipulating a number of aspects of the tax code that hedge fund managers justified their lower tax rate. In December, it was codified with the Brady Amendment.
According to nytimes.com, lobbying and pushback on Capitol Hill was so strong that Gary Cohn, a former top Goldman Sachs and current executive director of the White House’s National Economic Council, could only “extend the ‘holding period’ for investments that qualify for the tax break to three years from one.” This was laid out in the Brady Amendment, which also made it so the only way to avoid the holding period is for the carried interest to be paid to a corporation, rather than an individual. Cue the mad scramble to Delaware.
Delaware is the easiest state to set up an LLC. By creating one and putting their carried interest in it, hedge fund managers can elect to be treated as S-corporations. Unlike C-corporations, like Apple, which is publicly traded, an S-corp is easier to create and would also allow money managers to qualify for an exemption from the three year holding period and be taxed at the lower rate. Due to this, there was a 19% increase in the number of LLCs incorporated in Delaware during December.
So what’s being done about this?
Nearly two months after passage of the tax bill, Treasury Secretary Steven Mnuchin is now addressing how the administration has exacerbated the problem. Promising his department would eliminate the loophole in a congressional hearing Wednesday, Mnuchin is only acknowledging the loophole he created.
Mnuchin has given his department a two week deadline to fix the Brady Amendment, which virtually legalized the original carried interest loophole by extending the holding period, and added another one through the corporation language. While rectifying this latest loophole is welcome, it does not remove the actual carried interest loophole. Whether the holding period is extended further, or S-corporations are disallowed for hedge fund managers, the special interest tax rate is still available to those it was not expressly intended for. Trump has already voiced his opposition to this loophole, so when will Mnuchin finally address it head on?