Carried Interest Loophole and Proposed I.R.C. § 710

Executive Summary

There is tremendous influence of finance and Wall Street in the Biden Administration and the current control of the US Congress. Therefore, financial reform is difficult to enact. Why would the people involved in both Wall Street and government hurt their wallets? One of the largest mechanisms of wealth creation among the rich is carried interest. The mechanism of carried interest is where limited partners (LPs) make income from long-term investments that are taxed at a lower rate. Currently, the tax rate for carried interest is 20%, however if carried interest income was taxed at the ordinary income rate then the tax would increase to 37%. The solution to bridging the income gap cannot just be raising the tax. With Proposed IRC 710, it taxes carried interest as ordinary income and the losses are characterized as ordinary losses. Critiques of this proposed law are that it focuses on the partnerships rather than the partners and it includes C corporations. If these critiques were fixed it would be a viable option to close the carried interest loophole.

Rationale

Wall Street and finance have gained a lot of influence on the US financial System as a whole. The financial industry contributes a lot to US economic output. According to Guatum Mukunda of the Harvard Business Review, “In 1970 the finance and insurance industries accounted for 4.2% of U.S. GDP, up from 2.8% in 1950. By 2012 they represented 6.6%” (Mukunda). The nearly three-fold increase of the finance industry’s portion of the US economy, when measured by GDP, has enabled its increased influence. They can take advantage of its influence to push legislation that is friendly to the finance industry. One of these pieces of legislation in the tax code is the carried interest loophole. The loophole allows money managers of hedge funds, venture capital, and private equity to treat capital gains from the funds as their income while paying a much lower tax rate on those earnings. It is a major tax benefit for the industry where it essentially allows them to increase income while being taxed at a lower rate. With this advantage, the firms of high finance have made more and have been taxed less. A specific example is in private equity, the global buyout deals have “roughly doubled in 2021, dwarfing the previous peaks and breaking through the $1 trillion ceiling for the first time” (Bain).This is noteworthy that this occurred during a global pandemic, where many portions of economies went through an uncertain period.

One of the main reasons why this advantage has allowed for hedge funds, venture capital, and private equity to benefit is the lobbying and the industries influence inside government. The lobbying share of investment and securities is about “$108.53 million dollars in 2021” (Statista). In the 2020 election “Wall Street executives, their employees and trade associations invested at least $2.9 billion into political initiatives’’ (CNBC), which is quite an abundance of money for just one election cycle. Therefore, the money and influence they bring into the inner workings of the US government is quite large. Another example of Wall Street’s influence on the US government is that some high-ranking employees that either work for the treasury or the Biden Administration are former Wall Street employees themselves. For example, former high ranking BlackRock executives are a part of the Biden administration. BlackRock is the largest asset manager in the world with $10 trillion in assets under management (AUM). A couple of the former high-ranking BlackRock include the former BlackRock investment executive Brian Deese. He leads “Biden’s National Economic Council, effectively serving as his top advisor on economic matters. Biden also tapped Adewale “Wally” Adeyemo, a former chief of staff to BlackRock chief executive and longtime Democrat Larry Fink, to serve as a top official at the Treasury Department ” (Natarajan and Martin). These are just a few examples of high-end wall street executives working in high-ranking positions inside the government. This relationship exists due to the way the lobbying system is set up in the United States. Where lobbyists seek to influence (a politician or public official) on a policy or an industry as a whole (Oxford). However, this relationship is different because there are actually investment employees inside the White House instead of lobbyists advocating for a certain policy. This is worrying because if the government employees were or are a part of Wall Street then why would they advocate eliminating one of the largest tax breaks in their industry. This makes us ask how Wall Street has amassed a lot of influence and how have they maintained the biggest tax loophole for their benefit for so long. This then allows us to ask the question on how does this “the carried-interest loophole” work?

Carried Interest Explained

Carried interest can be explained by making sure that we understand the concepts and the taxation behind it. Private equity funds, hedge funds, and venture capital funds all have some sort of fund manager or asset manager that are the temporary owner of assets who invest for the long term. These private equity funds, hedge funds, and venture capital funds all have a general partner which is the firm that manages the fund and makes sure the fund managers are doing an adequate job. Many fund managers make money through carried interest, which is the primary source of income for the general partner. This usually equals to about 20% of a fund’s returns. The general partner passes the fund’s profit’s along to the fund’s managers (Chen). The reason why it is called “carried interest” is because the general partner does not have to invest any money but gets a carried interest that is paid back to the investors and distributes the profits to the fund managers or asset managers. The way the profits are distributed is called a “distribution waterfall’’. The waterfall is a process where the profits of the investment are distributed among the contributors of a group or pooled investment. This then characterizes the pecking order that describes the rank in which distributions will be dealt to the limited and general partners (Ganti). The carried interest for a fund “is only earned if a fund achieves a pre-agreed minimum return” and it “involves a 2% annual management fee” that is guaranteed no matter what happens to the investment (Chen).

The taxation of carried interest usually “qualifies for treatment as a long-term capital gain taxed at a lower rate than ordinary income”. The minimum length of time that an investment could be held to qualify for the 20% long term capital gains tax is about three years (Chen). The reason why it is called long-term is because it may take years to exit from an investment by these firms. The individual investment might be complex, and it may involve many different firms and investors, and it will take about 3 years or more to exit. The main problem pointed out is the taxation of carried interest. The concepts of carried interest and tax law might seem convoluted, however the history of its use in the United States is quite straightforward.

History of Carried Interest

In the United States, the use of carried interest started in the beginning of the 20th century. According to Alec MacGillis of ProPublica, carried interest “has roots in the oil and gas industry of the early 20th century, when partners doing the actual work of oil exploration using other partners’ investments had their share of profits taxed at the capital gains rate” (MacGillis). The taxes involved have allowed this element of private investment to thrive, partially due to the tax law involved. There are two major tax laws involved with carried interest that have led to the loophole having a larger impact. One of the tax laws is the 1954 Tax Reorganization. This tax law basically exempts the portion of capital interest from providing a property to a partnership from being taxable/ from taxes (Galaro and Crespi, pg.7). Later, the treasury tried to interfere with the result of the 1954 tax reorganization by trying to make a clarification between profit and carried interest profits. According to the SMU law review, the “Treasury Regulations for Section 721 were an attempt to fill a gap left by Congress. Unfortunately, in explaining the corrective, the Treasury created more questions than answers. The real mistake was not amending the regulations or publishing further guidance on the difference between profits and capital interests ”(Galaro and Crespi, pg.10). However, during that time they tried to claim that this regulation did just enough to draw this clarification. Later in the article published by the SMU Law review, it states that “the Subcommittee on Internal Revenue Taxation reported to Ways and Means that Regulation 1.721–1(b)(1) provided proper results. Furthermore, the subcommittee found capital and profits interests readily distinguishable by liquidation value”. Which basically means that the capital and profits will be distinguished by how many physical assets they have if they were to go out of business. However, the IRS did not determine the distinction between carried interest and profit until 1993 (Galaro and Crespi, pg.10). This delay in distinction means that the damage is already done and there is not a lot that the US government could do to reverse these damages even if they were to close the loophole. The lack of suitable regulation has shown the harmful effects of the Treasury’s “hands off” behavior towards carried interest (Galaro and Crespi, pg.5). With the lack of policy that has been effective to sequester carried interest, we must understand the taxation problem that it creates.

Taxation Problem with Carried Interest

If we are going to somehow resolve the carried interest loophole, then we need to address the problem of eliminating it in a way that does not cause economic harm. Many people believe the tax on carried interest is too low. According to the National Tax law, in the current tax law “Section 55(b)(3) provides that the preferential rate for dividend–and–gain income also applies under the individual alternative minimum tax (AMT). If an individual owned a portfolio company and held it for longer than one year, income from its sale would generally be long–term capital gain. Also, distributions from a portfolio company that is a C corporation would generally be qualified dividends. Therefore, much of the income generated by the company would receive the 15 percent rate if the managers, or other individuals, directly owned the company.” (Viard, pg. 3). Since carried interest is classified as long-term capital gains it seems to be not taxed at a sufficient rate if money managers are only being taxed at such a low rate like 15 to 20%. With these fund managers making a lot of money we can assume that they are in the top tax bracket. According to the IRS, the top tax bracket should be 37% with the earnings upwards of $500,000 (IRS). In a recent survey conducted by Heidrick & Struggles in 2019, the average salary and bonus pay of a limited partner in private equity is about $1 million (Heidrick & Struggles). Therefore, the amount that they are making fits into the top bracket but since a large amount of their earnings is in carried interest, the money they make from investments are taxed at the lower long-term capital gains rate.

However, if we just raise the long-term capital gains tax then it has the potential to create unintended consequences by causing problems and economic harm. According to the US Chamber of Commerce, they predict if a 98% tax increase is enacted on carried interest capital gains , then they estimate that there will be a “loss of 4.9 million jobs within five years across the United States; Declining tax revenues. Combined federal, state, and local governments’ annual net revenue losses could total $96 billion (revenues used to fund other programs) by year five, and lost retirement earnings. In particular, pension funds would lose up to $3 billion annually (a loss to pension fund retirees, which may force state and local governments to make up such shortfalls)” (USCC). The effects of changing tax rates might create more problems than previously thought. In fact, it might create more problems than just leaving carried interest alone. According to the DePaul Law Review, the closing of the carried interest loophole might reduce the funding that early-stage companies could receive from investors. Which will have a lasting impact on the overall macroeconomy that will make these companies create fewer jobs and generate less tax revenue (Maxwell, pg. 690). The problem with this claim is that it only applies to a 20% tax on the carry before the profits from the funds reach the hands of the General Partners (Maxwell, pg. 681). This means that the claims that this paper makes only applies to a raise in a tax, which is a simple move that could have negative ramifications as stated above. Therefore, the complicated problem of carried interest will call for a complicated solution.

Proposed I.R.C. § 710

In 2010, the house tried to pass a bill called the American Jobs and Closing Tax Loopholes Act of 2010, which basically tried to close all tax loopholes like carried interest. Additionally, it tried to clean up unemployment due to the recent 2008 financial crisis. This included a measure called Proposed I.R.C. § 710 that states carried interest income will be taxed at the same rate as ordinary income. However, the losses on carried interest, that are usually taxed as ordinary losses, will only become tax deductible if the carried interest income was earned in the previous years. When there is a sale of investment interest, any profit from the sale will be taxed as ordinary income. The losses will only be recharacterized as ordinary losses if they occurred during the previous years’ net income and net losses. It also states that Proposed I.R.C. § 710 will override the general partnership rules regarding the distributions of partnership property and this will instead replace it with the mechanism of taxing the distributions immediately although they are just distributions of money (Sacks, pgs.458–459). This is a complicated tax, and it is generally not just a raise on the long-term capital gains tax. This tax would only really be used in certain scenarios. This tax would be generally regarded as a special tax only applied to carried interest. However, there are some critiques about Proposed I.R.C. § 710. One of them would be the effect that the regulation has on C corporations. C corporations currently receive a minimal benefit from carried interest. However, with Proposed I.R.C. § 710 there their business deductions could possibly be deferred or disallowed. This seems to be a redundant mechanism because any taxation of carried interest should exclude C corporations (Sacks, pgs.462). Another problem with Proposed I.R.C. § 710 is that it puts too much emphasis on the partnerships, rather than the actual partners themselves. This allows for the creation of artificial “buckets” where the carried interest income from one fund cannot be counteracted by losses from carried interest from a different fund. This provision allows for fund managers to manage multiple separate funds while earning carried interest on some or all of them, which is very problematic (Sacks, pg. 462).

One of the fixes that should be facilitated to Proposed I.R.C. § 710 is that C corporations should be excluded from Proposed I.R.C. § 710 because “carried interest recharacterization is punitive when applied to corporations because it generally defers deductions to which corporations are otherwise legitimately entitled and sometimes entirely disallows bona fide losses’’ (Sacks, pg. 464). The other fix that should be facilitated is the focus should be on partners not the partnership. The focus should be shifted from the losses confined in the partnership level and it should expand through to each and every partner. Without this focus on the partners, they usually would face some form of punishment until one of the partners has an adequate amount of income to counteract the punishment (Sacks, pg. 465). These two problems can be easily fixed if they do not include the C corporations and focus on the partners then the Proposed I.R.C. § 710 could become a viable option on closing the loophole.

In conclusion, the proposed I.R.C § 710 is a step in the right direction for carried interest financial reform. The critiques involved with this proposed regulation could be a problem, but if they were fixed Proposed I.R.C § 710 is a great solution to the carried interest loophole. With all the problems with the carried interest law in the United States, it goes to show how effective financial reform can make change without affecting the free market.

References

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