Carried Interest Loophole
- Karen McGinnis
- Aug 13, 2022
- 5 min read
Carried Interest Loophole
After researching this subject, I came to a startling conclusion. One needs a BA, MBA, PhD and years of experience in the investment and tax world (CPA, tax law degree?) to understand the carried interest loophole. Since this was just dropped from the recently passed national legislation, my next question was…. how many of our legislators possess these qualifications and experience? The answer is few to none!!
Without this level of education and experience, how did these same legislators navigate their way through this legislation, understanding clearly enough to know whether to support, exclude, or modify the effects and rules regarding carried interest? Apparently, the answer is the same as it has been for many such complex subjects that come before the Congress. I will not begin to attempt to determine the right or wrong of this issue, nor cast aspersions on those who have passed or vetoed it. Those positions and conclusions are up to the reader. What I will attempt to do is explain some of the terms involved in understanding the carried interest loophole. It is interesting to note how it effects the tax rate, tax base, and the parties being taxed.
The first step in understanding the issue is to become familiar with the terms involved. Like any subject or occupation, the issue has a vocabulary of its own. Learning the vocabulary is one step closer to mastery. Good luck!
Carried interest: A share of the profits by a general partner of a private equity, venture capital or hedge fund. Unlike the “interest” that we are familiar with that is paid on a savings account or CD, this is a compensation aligned with the return or profit generated by the investment. It is treated as a long-term capital gain.
Carry: Same definition as carried interest. A share of the profits of an investment that is paid to the investment manager. It is a performance fee which rewards the manager for increasing the performance of the investment. Could be that a 20% “carry” fee is paid on every dollar returned to the investor.
Annual Manager’s Fee: Annual payment made by the partners in an investment to the fund manager. It is part of the cost of having your assets professionally managed.
2/20 fee system: 2% of the profit goes to the managing company of an investment, and 20% of the profit is paid as a performance fee. It is a percentage of the profits which are paid back into the fund.
General Partner: Two or more entities (parties) who agree to invest and then share in the profits, losses, and taxes on an investment.
Hedge Fund: A pooled investment fund with limited partners that deposit funds to create an investment vehicle that caters to high-net-worth individuals or to institutional investors. They “hedge“ risks by buying and shorting assets in favor of a long term strategy to create a profit. Often diversifying investments also seeks to “hedge” against a loss by one investment within the fund.
Investment fund: Investment product created solely to gather investor capital, invested collectively through a portfolio of varied forms of securities.
Hurdle rate: Minimum rate of return on an investment required by the investor. Guides a manager in choosing an investment, the minimum acceptable rate of return.
Clawed back: A return of the money that might have previously been paid out, due to a change in circumstances of the investment in which that pay out was in error and is then “clawed back" or returned to the fund.
Stock buy backs: A stock exchange listed company uses cash created through net profit to purchase its own stock. It is an attempt to create value for its stockholders, reduce debt, realign ownership of the company, and/or increase control of the company’s movement.
Shorting, shorts: An investor (or fund) wagers that a stock will drop in price. He sells the stock. When the price drops, he buys the stock at the new lower price.
ROI, Return on Investment: A performance measure used to evaluate the profitability of an investment. It measures the amount earned relative to the amount invested. To calculate, divide the profit by the amount invested. The resulting percentage is the return on investment.
Ordinary Income: Any type of income taxable at ordinary tax rates such as salaries, tips, wages, bonuses, commissions, rental income. Money earned from physically working or of an investment working. Assumes a one-year term.
Long term Capital Gains: Taxed at a lower tax rate than ordinary income. Carried interest now qualifies as a long-term capital gain.
Lock-up period: Length of time that money must be invested in a fund before a withdrawal is allowed.
With these brief and simplistic explanations of the terms involved, it is possible to begin to examine the carried interest loophole that was dropped from recent legislation. We must ask who benefits from the continued existence of a tax loophole around carried interest.
Carried interest is a benefit to general partners. General partners are “accredited investors” who have enough assets and stability to invest in risky investments that have a long payoff period and potential for a high rate of return. Because they are taking risks, have attached responsibilities for losses if any should occur, they expect large returns. Carried interest loopholes move their tax rates on those returns from that of ordinary wages or income to that of long-term capital gains. That decrease in the tax rate means they keep more of the money their investment generates. They pay less in taxes.
Legislation passed in 2017 addresses carried interest tax rates in terms of time, but not in terms of percentage due or any other meaningful way. The process remained as it had always been, a means of paying less tax on income or profit. Only the time period for holding the investment was affected. It increased from one year to three years. There was no other change. Interestingly, persons using this particular investment strategy usually held their investment for three years or longer. There was little to no impact. Legislation that would make carried interest taxable as the ordinary income it is, did not pass Congress.
The reality of the situation appears to be that at present, the chance of making a change from long term capital gain to ordinary income has a negligible chance of passing Congress. Such a change would generate approximately 14 billion dollars more in taxes. The influence of lobbyists continues to weigh heavily on legislators when faced with the challenge of making this change.
We see the need to change this loophole continuing. Many see the issue in a catch phrase that is often repeated. “Follow the money.”
The Inflation Reduction act which originally had contained a change to the carried interest loophole, passed without it through both the Senate and House of Representatives on August 11, 2022.
Some sources for further study of this issue:
as well as other sites reached by using a search engine under the search for definitions and discussions of “carried interest” or the terms listed in this post.
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