The chairman of the powerful Senate Finance Committee has introduced legislation to close the carried interest loophole to “ensure hedge fund managers and private equity CEOs pay their fair share in taxes.”
The Ending the Carried Interest Loophole Act, introduced by Committee Chairman Sen. Ron Wyden (D-OR) and Committee member Sen. Sheldon Whitehouse (D-RI), seeks to close the alleged loophole by preventing the deferral of tax payments and recharacterization of wage-like income to capital income.
The senators note that previously introduced bills only addressed the recharacterization of income, while their bill seeks to close the entire loophole by addressing the deferral of tax payments. To that end, they note that the Joint Committee on Taxation (JCT) estimates that their bill would raise $63 billion over 10 years, while previous bills that did not address the tax deferral would raise just $15.6 billion over the same period.
“One of the most indefensible loopholes in the tax code allows wealthy private equity managers to be taxed at lower rates than nurses treating COVID patients and avoid paying any tax year after year after year. This is an issue of fairness,” Sen. Wyden said in a statement. “Importantly, my bill closes the entire loophole—private equity managers will no longer be able to defer paying tax for years, if not decades.”
General Provisions
To prevent the recharacterization of income, fund managers would be required to recognize annual compensation that would be taxed as ordinary income and subject to self-employment taxes. Annual compensation would be determined using the estimated forgone interest on an implicit interest-free loan from investors to the fund manager at a prescribed interest rate, according to a summary of the bill.
In addition, to end deferral of tax payments, the bill treats transactions between fund managers and investors as occurring outside the partnership, decoupling compensation from future sales of investments and ensuring the value of the fund manager’s carried interest is taxed from the outset. Under current law, the fund manager’s carried interest is taxed as income from the partnership, which allows the deferral of tax payments until future investment sales, the summary explains.
To account for the recharacterization to wage-like income and avoid double taxation, the fund manager would also realize a long-term capital loss equivalent to the annual compensation, which could offset the fund manager’s future long-term capital gain from sale of an investment. As with all capital losses, the loss could be used to offset long-term capital gains or carried forward.
For example, the senators explain, if the fund manager receives a 20% carried interest in exchange for managing investors’ capital of $100 million, and the prescribed interest rate for the tax year is 14%, the fund manager would pay the top ordinary income tax rate of 40.8% tax on $2.8 million in deemed compensation.
On the Radar
Addressing carried interest has been on various lawmakers’ radar for quite some time now, suggesting that the Wyden-Whitehouse proposal could surface in legislation moving through Congress later this year.
President Biden’s fiscal year 2022 budget also includes a proposal that seeks to address carried interest, but it doesn’t go as far as Wyden’s bill. Biden’s proposal would tax as ordinary income a partner’s share of income on an “investment services partnership interest” in an investment partnership, regardless of the character of the income at the partnership level, if the partner’s taxable income (from all sources) exceeds $400,000.
In addition, the 2017 Tax Cuts and Jobs Act included a scaled-back provision stipulating that certain partnership interests received in connection with the performance of services are subject to a three-year holding period in order to qualify for long-term capital gain treatment.
