When Are You Removing the Carried Interest Loophole, Mr. President?

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When Donald Trump campaigned for President he promised to get rid of the carried interest loophole, saying that ‘hedge fund managers are getting away with murder.’ A year later he said he’d get rid of this loophole that’s been “so good for Wall Street investors”. Now, yet again, Trump has promised that he will close the carried interest loophole after enshrining it into law under TCJA.

How many times do we have to hear the same lie?

Wait, what’s the carried interest loophole?

It’s a loophole in the tax code that allows wealthy investment managers to pay a lower tax rate on their income than most middle-class Americans. The basic scam is that investment managers write their contracts with their clients as “partnership agreements,” and then claim that since their “partners” were earning long term capital gains, that they (the people who did the work of operating the fund) should pay taxes at the same rate as the investors (their clients).

Imagine trying to sell your used car, and offering your neighbor twenty dollars to wash the car for you. Say he came back with a contract saying that you and him are partners in the car selling enterprise, and you will split the proceeds from selling the car by giving him the first twenty dollars, and you keeping everything else. Should he then be entitled to pay taxes at your lower tax rate on the twenty dollars? Does that agreement make his $20 a capital gain? No it’s still obviously income, but that is essentially what fund managers taking advantage of carried interest have been claiming.

So, what changed after the passage of TCJA?

Carried interest used to be an obscure loophole caused by the IRS’ interpretation of different provisions about taxation of partnerships. Since the Trump tax bill, however, the loophole is actually enshrined in the text of the law (26 USC 1061).  The bill did change carried interest to only apply to gains from assets held for over three years (instead of one year as is the case for other long term capital gains), but this affected only a small percentage of the fund managers who take advantage of carried interest.  

Additionally, the new law is very confusing and unclear (even to tax attorneys) because they are trying to make sure that the benefit accrues to Wall Street fund managers, but can not be used by Main Street partnerships (dentists, etc.).

Why did Congress make this special tax break for hedge fund managers official?

I honestly don’t know:

  • Maybe they think that there is a shortage of people willing to be fund managers (despite their multi-million dollar salaries), and we need to encourage more people to get Wall Street jobs.
  • Maybe they think that financial engineering is the quintessential American occupation, and those people who do it deserve a special break.
  • Maybe they think that the fund managers will go on strike if they are required to pay taxes at the same rate as everyone else, and that would lead to the demise of Western civilization.
  • Maybe they think that fund managers are more deserving than truck drivers and nurses and teachers and other people who work for a living.
  • Or, maybe, they happen to have met a few fund managers (probably at political fundraisers) and only heard their side of the story.

The passage of the Trump tax cuts not only failed to fix carried interest, it actually made things worse by codifying this obscure loophole for wealthy hedge fund managers into law. Despite promises on the campaign trail to close it, during Trump’s term in office we’ve moved further away from eliminating this tax loophole. And now, seventeen months after signing the bill, President Trump has finally noticed this? Is the recent statement another empty promise by the President, or does he actually intend to take action against this cheat in our tax system? The answer is unclear, but I’m not optimistic.

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