United States

The future of carried interest?

INSIGHT ARTICLE  | 

What are the candidates saying about carried interest?

The two presumptive major party presidential candidates both support changing the current tax treatment of carried interest.  But what does that mean?

Hillary Clinton supports “ending the ‘carried interest’ loophole” as well as enacting a “Buffett Rule” to ensure that “no millionaire pays a lower effective tax rate than their secretary.”  In addition, Bernie Sanders -- who could influence the party platform even if he is not the candidate -- pledged to “end the carried interest loophole that allows billionaire hedge fund managers to pay a lower tax rate than nurses and truck drivers.”  In addition, he pledged to render the benefits of carried interest almost worthless, by eliminating capital gains rates for couples with income over $250,000. 

Donald Trump would end the current treatment for “speculative partnerships that do not grow businesses or create jobs and are not risking their own capital.”  However, taking personal compensation in the form of a profits interest in the annual operating earnings of a going concern could become more attractive, even without a capital gains break, since he would only tax operating business income at 15 percent.

There is evidently as much uncertainty about how the law might change as there is about whether or when it will change.  What are some of the options?

Recap:  what is carried interest?

A carried interest or profits interest arises when the manager of a partnership -- or other employee or service provider to the partnership -- is compensated for his managerial services with a percentage interest in the partnership’s future income or gains.  That may include capital gains if the partnership is engaged in buying and selling assets taxed at capital gains rates – or if the partnership is a business that sells all of its assets, including goodwill or other business assets generally taxed at capital gains rates.

When the taxpayer receiving the carried interest or profits interest is the founder or full-time manager or employee of an operating business, everyone seems to accept that capital gains treatment for his “piece of the action” is appropriate.  It is the American dream, so to speak. 

The leading Presidential candidates seem to believe it should be different if the partnership is not itself a conventional operating business, but is a fund that invests in commodities, securities, real estate, or equity interests in other businesses.  As a technical matter, it can be argued that the manager should be treated no differently than the manager or employee of a conventional business, and should be able to be compensated with a “piece of the action” that is taxed at capital gains rates.  But many believe that the manager’s activities look too much like managing money or managing real property, not managing a business, and should not be able to enjoy the same treatment that is provided for a partner who is a full-time manager or employee of an operating business. 

Any proposal to change the treatment of carried interest must first define the term. 

At one extreme, new rules could apply across the board to any partnership interest received or held on account of the holder’s provision of services to the partnership – including, say, the founder of a tech company who receives a substantial interest solely in exchange for his services in creating the company, without having to put up any substantial amount of cash or financial capital.  Technically, some would argue that is a carried interest. 

Others might say  the new rules should only apply to partnerships that are investment or hedge funds that buy and sell commodities and securities on the financial markets for capital gains, or to private equity funds that buy and restructure other businesses, hoping to resell them at a capital gain, or to partnerships that buy, build, or hold real estate with a view towards realizing a capital gain.  

Thus, the first question for the politicians is what is the scope or definition of the partnership profits interests that will be subject to any rules.

What is the problem, what is the remedy?

Once it is defined, how should it be taxed?  When a profits interest is granted, it typically has no readily ascertainable value.  For that reason, the IRS and some courts have allowed it to be assigned a value of zero when it is granted.  Thus the grant itself does not give rise to any tax, and if capital gains are later generated a portion of them are passed through and taxed to the holder as capital gains. 

Congress or the IRS could change this rule, and insist that the value of the interest be determined when it is issued, and taxed as ordinary compensation income at that time,  as if it was a cash bonus that the recipient received, paid tax on, and then used to purchase an investment in his employer.  That would be very difficult to apply, since the IRS, taxpayers, and the courts would be tied up in disputes over valuation. 

Congress could keep the zero valuation at issuance, but insist that all or a portion of any later capital gains be recast as ordinary income.  It could be 100%, 50%, 25% or a number determined based on a formula, perhaps linked to how much the underlying assets have actually appreciated.  For example, if the assets appreciated at 5% per year, perhaps they would be taxed entirely as ordinary income, but if the assets appreciated at 15% per year, then two-thirds of the gain, the amount in excess of a 5% return, might retain its capital gain treatment.  Thus, a relatively certain return would be treated as ordinary income, but a riskier, more speculative return would be taxed at capital gains rates.  That could make sense to reinforce the policy underlying capital gains rates in the first place – promoting entrepreneurial risk.

Other approaches?

If Congress completely eliminated capital gains breaks – as was done in the landmark 1986 Tax Reform Act when the top rate for all income was set at 28% -- there would be no real need to change the rules for carried interest.  The same is true if Congress eliminated capital gains breaks for anyone with income over $250,000 as Bernie Sanders has proposed.  In that event, very few managers would get any benefits from carried interest.

If Hillary Clinton’s proposal advanced to impose a minimum tax rate of 30% on income over $1 million, that would also substantially cut back on the benefits of carried interest.  If the capital gains rate were 20% and the ordinary income rate were 40%, and a millionaire manager whose income was entirely carried interest was subject to a minimum rate of 30%, it would be the equivalent of taxing half of his capital gains as ordinary income.  That would seem to meet the objectives of  Clinton and Sanders to ensure that hedge fund managers pay higher tax rates than moderate income taxpayers.  That may already be the case, as regards “average” or “effective” tax rates, but it would also be the case for “marginal” tax rates under such a proposal.

Finally, at least in the case of many operating businesses, if Donald Trump’s proposal is enacted to tax all business income at 15% it may become attractive to hold onto certain successful businesses as “cash cows” whose income is taxable at 15%, rather than selling the business for a lump sum, just to ensure that the profits -- attributable to the business becoming more profitable than it was when it was purchased -- are taxed as capital gains.  That would also make carried interest – and capital gains generally -- of lesser importance to some taxpayers.

Final thoughts

Finally, just because the current Presidential candidates agree – and assuming that one of them becomes President – there is no guarantee that anything will get done.  With a divided government, we may be in for another 4 years of gridlock.  One thing is almost certain – carried interest is not likely to be fixed as a stand-alone measure.  If the Congress and the President cannot agree on a comprehensive reform, an item like this is unlikely to be pulled out and dealt with separately.  It may be too valuable as a bargaining chip.  Remember that it was widely expected that there would be a change to the rules governing carried interest in 2012 when the Congress and the President were forced to reach a consensus deal on the tax rates that would replace the expiring Bush-era tax cuts.  To the surprise of many, nothing was done about carried interest, and that could happen again.  

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