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What Would the New Carried Interest Loophole Proposal Do?

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.

An agreement reached this week between Senator Chuck Schumer, the Majority Leader, and Senator Joe Manchin III, Democrat of West Virginia, would take a small step toward limiting that special tax treatment. However, it wouldn’t completely remove the loophole and could still allow wealthy business leaders to have smaller tax bills than their secretaries, a critique of investor Warren Buffett, who has long argued against preferential tax treatment.

The fate of the provision was still uncertain given the slim majority held by Democrats in the Senate. They would need all 50 Democrats to support the legislation because Republicans are united in opposing tax hikes. But if the legislation were passed, the shrinking of the carried-forward interest 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 mean?

The agreement between Mr. Manchin and Mr. Schumer would further narrow the exemption in several ways. It would extend 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 bring in 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 only apply to those earning $400,000 a year or more, consistent with President Biden’s pledge not to impose taxes on those earning less than that amount.

The tax provision reflects 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 Arizona Democrat Senator Kyrsten Sinema, who opposed the measure, would block general legislation. Ms Sinema has so far not indicated whether she agrees with any of the tax provisions of the new package. Democrats were essentially betting that she wouldn’t block the larger bill because of a relatively small change that brings in revenue.

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 does the change mean 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. on 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.

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