2016 Presedential Campaign Issues: Carried Interest

Carried interest is a term that has been thrown around a lot during this Presidential campaign. The purpose of this post is to help define carried interest and help you understand the issues that the candidates are discussing.

Many hedge funds and private equity funds are structured as partnerships in which investors become limited partners and the funds’ managers are the general partner. The managers often take a considerable portion of their compensation for managing the funds’ investments in the form of a share of the funds’ profits.  In other words, the manager will make a lot of money if the investors make a lot of money. This interest in future profits is often referred to as a “carried interest.” A carried interest generally is a right to receive a percentage of fund profits without an obligation to contribute to the capital of the fund.Carried Interest3

Often, the general partner (GP) will receive a management fee of 2 percent of the fund’s assets plus 20 percent of profits that exceed certain hurdle rates. These hurdle rates might be 7 to 8 percent. The GP is incentivized to generate returns that exceed the hurdle rate, which is considered the minimum return for the investors.

Because these funds are structured as partnerships, they are taxed as partnerships and have a flow-through of income. The income that flows through maintains its character (ordinary, capital, etc.) Therefore, if a partnership invests in a capital asset, such as a stock, any gain (or loss) from the sale of that asset will be capital and will flow through to the partners as capital gain (or loss).

The management fee, less expenses, is generally taxed as ordinary income subject to self-employment taxes. The carried interest income is treated as any other flow-through income. If the investment income is capital, then it is treated as capital gains. If it is ordinary, then it is treated as ordinary.

What’s the ISSUE?
Obama, Trump, Jeb Bush, Clinton, and many others in Congress have agreed that the “carried interest loophole” should be closed. It has become a populist argument. However, is it really a “loophole” or rather part of our intricate Internal Revenue Code? How much tax revenue could be generated from this so called “loophole?” According to Obama’s 2013 Budget, “closing this loophole would raise more than $13 billion over the next 10 years.” $13 billion is certainly a lot of money, but its less than ½ of 1 percent of what the Federal government spends in a single year. It is roughly 4/100ths of 1 percent of the annual Federal spending.

One of the core questions is whether a carried interest received by an investment management firm should be viewed as a form of compensation for services, or whether it is more similar to an interest in capital. Compensation for services is taxed as ordinary income (you get a Form W-2 at the end of the year and you pay FICA), while capital gains receive favorable tax treatment (20% max rate with additional surtax of 3.8%). The Federal income tax treatment of partnership profits interests for services (of which carried interests can be an example) has evolved through litigation and Internal Revenue Service positions. For a thorough review of the tax treatment of carried interest income, see the report prepared by the Staff of the Joint Committee on Taxation here. It's 55 pages long - not a short sound bite.

Congress has already drafted a few bills to tax carried interest as ordinary income. However, it does not appear that it would increase tax revenue much, nor does it appear that it would even be effective. Through a small change in structure, hedge fund managers could achieve the same capital gain results. This change could include loans (most likely non-recourse) from investors to the manager for the purchase of the interest in the fund. The result is that the manager has the same interest, same tax treatment, as does the investors.

ME Comment: We expect to hear more about how all of the candidates will tax carried interest. At least now, you know what they are getting at!

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