“Carried interest is on the table,” said White House Chief of Staff Reince Priebus on ABC’s This Week last Sunday. “The president wants to get rid of carried interest so that balloon is not going to stay inflated very long, I can assure you of that.”
While the so-called “carried interest loophole” is a frequent punching bag of populist politicians, it is generally misunderstood. Experts explain that the tax code treats carried interest as it does for specific reasons, and while President Donald Trump has claimed it primarily is a boon for hedge fund managers, it’s more often a policy that affects venture capital and private equity investments.
Investment managers often receive carried interest payments instead of income. Critics have argued it’s being used unfairly as a tax loophole since these payments are not taxed as income. But the carried interest discussion is often plagued with misconceptions. The policy simply allows investment managers to receive a percentage of gains made through investments rather than a salary. The tax treatment can result in a lower tax rate, but it’s primarily designed to incentivize managers to create more returns.
“The current rhetoric misstates what the treatment actually is in several respects,” American Enterprise Institute scholar Alan Viard told InsideSources. “If the treatment was what the rhetoric suggested, I think it would be bad. But the rhetoric just isn’t a correct description of what the current tax law is doing.”
Trump spoke out against the carried interest loophole during the campaign, as well. He promised to eliminate the policy in his economic growth plan. The president and his administration are likely referring only to ending the lower tax rate, though some of the administration’s rhetoric on the issue has been very imprecise. The administration has not yet detailed exactly what it hopes to do. Other Republicans have fought past attempts to eliminate the carried interest loophole.
“When I hear someone like the president say we’re going to get rid of carried interest, I don’t interpret that as we’re going to eliminate the carried interest fee structure for compensating fund managers,” Scott Greenberg, an analyst at the Tax Foundation, told InsideSources. “I hear that as a shorthand for we are going to eliminate the ability to claim the lower capital gains rate on their carried interest income.”
The administration still faces potential risks with implementation. The president could just try to address the tax portion, but even that comes with plenty of obstacles. A proposal that only targets investment managers could create further complications by inadvertently adding a new tax rate.
“Presumably they’ll want to reclassify this as business income,” Viard, who has written extensively on carried interest, said. “The problem with the Trump plan is that we now have three tax rates floating around, not two. There’s the ordinary tax rate on wages, there’s the 15 percent rate on business income, and there’s the 20 percent rate on capital gains.”
Investment returns like capital gains or dividends are taxed at a lower rate than income. Investment managers that are compensated through carried interest often pay the lower tax rate since they are receiving a percentage of the capital gains or dividends.
“There’s this other issue that, what fund managers are doing looks an awful lot like work, and therefore their compensation looks like it ought to be treated as wages and salaries,” Tax Policy Center fellow Donald Marron told InsideSources. “I find that compelling. I don’t technically view that as a loophole issue, more a description of what we think their work is.”
If the tax code were changed, investment managers would likely then have their carried interest payments taxed like income. Viard contests the criticism reflects a misconception of what carried interest actually is.
“People assume that the carried interest arrangement has been adopted solely for the purposes of tax minimization, and that’s not true,” Viard said. “It’s obvious that this arrangement is giving managers a stake in how the fund is doing for incentive capability reasons. What better way to motivate the managers to get the highest investment returns.”
Investment managers aren’t the only ones that benefit from the lower rates. Investors and others that make money through those investment gains only have to pay the reduced tax rate. Viard argues that proposed reforms should need an explanation of the reasoning if it only targets investment managers.
“I think the case for reclassifying this income seems uncertain to me,” Viard said. “Business partnerships, in general, are free to allocate their income among the partners as they wish, and it’s not clear why there should be an exception made in the case of carried interest.”
Viard adds there are other misconceptions that are driving the discussion. He notes it’s not true that carried interest payments are unique to investments since various business partnerships have formed similar arrangements. The lower rates don’t always apply either since some come from unqualified dividends or short-term capital gains.
“All the carried interest arrangement does is reallocate part of that income, 20 percent of it typically, from the investors to the managers,” Viard said. “There is a tax benefit there, but it’s not exactly a question of reclassifying income in the aggregate as being dividends and capital gains. It’s a question of how it’s allocated.”
Despite Trump’s rhetoric on the campaign trail, investment managers don’t always receive carried interest payments either. Trump described hedge fund managers as “getting away with murder” and stated: “They make a fortune, they pay no tax. It’s ridiculous, OK?” But reality often runs counter to these claims. The arrangement only really yields results for long-term capital gains and qualified dividends. It’s commonly used for private equity and venture capital investments, but not so much for hedge funds.
Viard believes if people understood carried interest better there wouldn’t be such an uproar. Some may still work to reform the system, but with a better understanding of what carried interest is meant to do. Greenberg notes that reforms may not even be worth it since it would require a lot of work with little in the way of potential benefits.
“When we’re talking about carried interest, we’re talking about a very small share of federal income,” Greenberg said. “It’s an interesting debate to have on the merits, and it’s an interesting policy topic to talk about, but it’s ultimately not as consequential as people make it out to be.”
The Congressional Budget Office estimated in 2013 that taxing carried interest as ordinary income would raise federal revenue by $17.4 billion over a decade. The potential savings pale in comparison to what the government is expected to collect in revenue over those ten years.
Democratic lawmakers have proposed several bills in recent years that are designed to reform carried interest payments. Viard notes the bills are often intricate but lack key details in how reforms should be implemented. Trump and his administration have not drafted a bill for their own plan yet.
