Carried Interest in the Political Crosshairs Again

Recently, it was reported that President Donald Trump proposed eliminating the capital gains tax treatment on carried interest in a meeting with Congressional Republican leaders. This request has reignited a long-standing debate over the fairness and economic impact of the current tax treatment of carried interest.

On the same day, Democrats in the House and Senate introduced bills to eliminate this tax treatment, signaling a rare moment of bipartisan agreement on the issue. The proposed changes have significant implications for investment fund managers, the broader financial industry, and the economy as a whole.

Understanding carried interest

Carried interest is the share of partnership profits a general partner receives from the investing partners for managing the investment and taking on the entrepreneurial risk of the venture. It can be taxed as either ordinary income or capital gain, depending on the nature of the income generated by the partnership.

Typically, carried interest is a form of equity compensation granted to investment fund managers (i.e., real estate, private equity, venture capital, or hedge funds) in exchange for their investment services. Fund managers benefit from long-term capital gains tax treatment (20%) on their carried interest when underlying fund investments are sold, as opposed to ordinary income tax treatment (up to 37%) that is typically imposed on wage or service income.

Historical context

Over the past 20 years, lawmakers have introduced various proposals to increase the tax burden on carried interest. For example, the Tax Cuts and Jobs Act of 2017 increased the holding period requirement to three years to generate long-term capital gains treatment on carried interest.

Most recently, there was a proposal to treat carried interest as an interest-free loan from the limited partners to the general partner, which would be taxable upon grant. Imputed interest on the loan would have been treated as deemed compensation to the general partners, regardless of profit generation. This proposal obviously did not go into effect.

Critics’ perspective of current tax treatment

• The current tax treatment of carried interest allows fund managers to pay a lower tax rate on their income compared to ordinary wage earners.
• The preferential tax treatment is seen as a loophole that benefits wealthy fund managers at the expense of broader tax equity. Eliminating the capital gains tax treatment on carried interest would increase tax revenue and reduce income inequality.
• Taxing carried interest at capital gains rates results in lower tax revenue, which could otherwise fund public services and infrastructure.
• Some argue that capital gains tax rates are intended to incentivize long-term individual investment, not to serve as a tax break for fund managers’ compensation.

Supporters’ perspective of current tax treatment

• Carried interest is not compensation for services. General partners receive fees for routine services, which are taxed at ordinary tax rates. Carried interest is granted for the value the general partner adds beyond routine services, such as their experience and investment network.
• Proposals regarding carried interest would be applied retroactively to previous transactions and partnership agreements established in prior years. This approach could undermine the predictability of the tax system and potentially discourage long-term, patient investment.
• The current tax treatment encourages investment and rewards risk-taking. Changes to this treatment could threaten future investment in important areas such as housing and infrastructure.
• Private equity and real estate funds often rely on carried interest as a key incentive, fostering capital allocation to projects that may otherwise lack funding.

Make your voice heard

If carried interest is an important issue for you, it’s crucial to reach out to your congressional representative and make your voice heard. Legislative advocacy is a vital aspect of being a real estate professional, and your involvement can help shape the future of this significant tax policy.