Carried Interest Is Back in the Headlines. Why It’s Not Going Away.

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For years, Democrats and even some Republicans, such as former President Donald J. Trump, have called for closing the so-called “carry interest loophole” that allows wealthy hedge fund managers and private equity executives to pay lower tax rates than entry-level employees.

Those efforts have always failed to make a major dent in the loophole — and the latest proposal to do so faltered this week, too. Senate leaders announced Thursday that they agreed to drop a modest change in the tax provision to secure the vote of Arizona Democrat Senator Kyrsten Sinema and ensure their Inflation Reduction Act, a broad climate, health care and tax bill.

An agreement reached last week between Senator Chuck Schumer, the majority leader, and Senator Joe Manchin III, a West Virginia Democrat, would have taken a small step toward narrowing the interest-based tax treatment. However, it would not have completely eliminated the loophole and could still have allowed wealthy business leaders to have smaller tax bills than their secretaries, a criticism of investor Warren Buffett, who has long argued against preferential tax treatment.

The fate of the provision has always been questionable given the slim majority held by Democrats in the Senate. And Ms. Sinema had previously opposed a carry-rate measure in an earlier, much larger bill called Build Back Better, which never got the 50 Democratic votes needed — Republicans are united in opposing tax hikes.

If the legislation were passed in the form Mr. Schumer and Mr. Manchin presented to him last week, the shrinking of the interest carried forward exception would bring Democrats just a little bit closer to realizing their vision of making the tax code more progressive. .

What is carry rate?

Carried interest is the percentage of an investment’s profit that a private equity partner or hedge fund manager takes as compensation. At most private equity firms and hedge funds, the share of profits paid to managers is about 20 percent.

Under existing law, that money is taxed at a 20 percent capital gains rate for top earners. That’s about half the rate of the highest individual income tax bracket, which is 37 percent.

The 2017 tax bill passed by Republicans left the carry-rate treatment largely intact, after an intense corporate lobbying campaign, but narrowed the exemption by requiring private equity officials to hold their investments for at least three years before committing. enjoy preferential tax treatment on their carry rate. interest income.

What would the agreement between Manchin and Schumer have done?

The agreement between Mr. Manchin and Mr. Schumer would have further limited the exemption in several ways. It would have extended that three-year period to five years, while changing the way the period is calculated in the hopes of reducing the ability of taxpayers to abuse the system and pay the lower tax rate of 20 percent.

Senate Democrats say the changes would have generated an estimated $14 billion in a decade, taxing more income at higher individual income tax rates — and less at the preferential rate.

The longer retention period would have applied only to those earning $400,000 a year or more, in line with President Biden’s pledge not to levy taxes on those earning less than that amount.

The tax provision echoed a similar measure initially included in the sprawling climate and tax bill passed by the House Democrats last year, but ultimately stalled in the Senate. The ‘carry interest’ language was removed out of concern that Ms Sinema, who opposed the measure, would block general legislation.

Why has the loophole not yet been closed?

Many Democrats have spent years trying to completely eliminate the tax benefits private equity partners enjoy. Democrats have tried to redefine the management fees they get from partnerships as “gross income” just like any other type of income, and to treat capital gains from partners’ investment as ordinary income.

Such a move was included in legislation proposed by House Democrats in 2015. The legislation would also have increased penalties for investors who failed to properly apply the proposed changes to their own tax returns.

The private equity sector has fought back hard, completely rejecting the basic concepts on which the proposed changes were based.

“There is no such loophole,” Steven B. Klinsky, the founder and chief executive of the private equity firm New Mountain Capital, wrote in an op-ed published in The New York Times in 2016. Mr. Klinsky said that when other taxes, including those levied by New York City and the state government, were accounted for, his effective tax rate was between 40 and 50 percent.

What would the change have meant for private equity?

The private equity sector has defended the tax treatment of carry interest, arguing that it creates incentives for entrepreneurship, healthy risk-taking and investment.

The American Investment Council, a private equity industry advocacy group, described the proposal as a blow to small businesses.

“Last year, more than 74 percent of private equity investments went to small businesses,” said Drew Maloney, chief executive of the AIC. the private capital that helps local employers survive and grow.”

The Managed Funds Association said the changes to tax laws would hurt those investing on behalf of pension funds and university endowments.

“Current law recognizes the importance of long-term investments, but this proposal would penalize entrepreneurs in investment partnerships by not giving them the benefit of long-term capital gains treatment,” said Bryan Corbett, the association’s CEO.

“It is critical that Congress avoid proposals that harm the ability of pensions, foundations and endowments to take advantage of high-quality, long-term investments that create opportunities for millions of Americans.”

Jim Tankersley reporting contributed.