Although a proposal to scale back the carried-interest tax deduction was cut at the last minute from the Inflation Reduction Act, that's likely not the last time foes of the tax break attempt to eliminate it, observers say.
“The carried-interest provision has been a hot-button issue for several years and is considered one of those nasty loopholes that politicians from both sides of the aisle have wanted to close,” said James G. McGrory, a partner with Armanino LLP in Philadelphia.
Carried interest is the awarding of a partnership profits interest to compensate managing partners of private equity, venture capital and hedge funds for their management services.
“Carried interest is typically taxed at the more favorable long-term capital gains rate rather than the ordinary income tax rate,” said Tyler Sterk, a CPA and wealth advisor at Kayne Anderson Rudnick in Los Angeles. “For individuals in the highest federal income tax bracket, this is a massive tax benefit—20% long term capital gains tax versus 37% ordinary income tax.”
It also means the tax break is a political hot potato, because it affords rich asset managers a tax break on what is essentially income. The benefit has become more glaring in recent times as the gap between rich and middle-class Americans has gotten wider and wider.
“Generally, income earned in connection with services is ordinary income and is subject to self-employment tax and income tax at ordinary rates,” said Jenny Zhang, senior tax manager in the Philadelphia office of Armanino LLP.
Private equity partners must hold their investments for at least three years to qualify for long-term capital gains, Sterk said. The provision struck from the Inflation Reduction Act would’ve increased that period to five years; President Biden also said that the five-year holding period requirement would’ve applied only to taxpayers with AGI of $400,000 or more.
“One side calls it … unfair and cites the high-income individuals and businesses benefitting from it,” said Peter C. Earle, economist at the American Institute for Economic Research. “The other side maintains that the lower tax rate provides incentives for financial managers to get involved in the risky assets and markets that alternative investments contemplate. They often add, correctly, that hedge funds, private equity and venture capital investments are a growing part of pension fund holdings, and as such the inability to attract talented/experienced managers with adequate compensation could have effects on tens of millions of individual IRAs, 401(k)s and so on.”
Beyond the proposal to bump the holding period to five years to qualify for the 20% tax rate, “a second proposed change was a bit more slippery,” Earle said. It would have added a “requirement that the five-year minimum holding time would only kick in after the investment vehicle in question is ‘fully invested.’ Does that mean 100%? Seventy-five percent? What if there simply aren’t enough opportunities at that moment and the fund is substantially in cash? Putting financial pressure on fund managers to invest beyond what they think is wise could wind up hurting investors.”
Could the carried-interest provision appear on lawmakers’ chopping blocks again?
“I doubt that there will be enough votes to get it changed in the near future, especially if the House is controlled by the GOP,” said Brian Stoner, a CPA in Burbank, Calif., adding that the tax revenue from carried-interest revenue was replaced by a new excise tax on businesses buying back their own stock. (The Inflation Reduction Act levies a 1% excise tax on corporate stock buybacks, beginning in 2023.)
“This provision has been a matter of controversy and discussions for over a decade," said Varun Vig, a director in the Personal Wealth Advisors Group and a member of the Financial Services Group at EisnerAmper in New York. “Being out of the Inflation Reduction Act doesn’t mean it will not come back in the future.”