There’s a tax loophole that traces its roots to cargo-carrying sea captains of the 1100s.
What’s remarkable about it in 2016 is that eliminating it is one of the few things that Donald Trump and Hillary Clinton agree on.
It’s called carried interest, and it’s a great deal for people who make their fortunes in private equity, such as Mitt Romney. Or in real estate, like Donald Trump. Or even investors such as Warren Buffett. Their compensation as partners in their firms is taxed far lower than most Americans’ salaries.
And yet it’s unlikely to come up at Wednesday’s debate. Both Trump and Clinton want to close this “loophole” and tax carried interest at the same rates as ordinary income. That’s a big change from 2012 when Mitt Romney stood by the policy that benefited him mightily.
“Presidential candidates rarely agree on tax issues, so Clinton’s and Trump’s agreement on carried interest is striking,” Steve Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center, said in an email.
How it works
Carried interest generally benefits partners and workers at investment firms, including those in private equity, real estate, and venture capital. It works something like this:
A private-equity fund buys up all or some of a company, makes some changes, and then hopes to sell that investment in a few years at a profit. The profits, if any, flow through a funnel that ends up in the bank accounts of investment managers and the investors who put up their own capital.
For the fund managers, this share of the profits is usually the bulk of their compensation. Investors often pay 2% of their assets to the operation of the fund, and then 20% on the profits on whatever the fund returns. For the fund managers, that 20% — often many millions of dollars — is taxed as capital gains, not ordinary income, so they find the much of their income taxed at a maximum rate of 20%.
This scenario is similar for venture-capital or real-estate organisations that pass profits on to staffers.
In contrast, salaried Americans face a top tax bracket nearly twice that — 39.6%.
The benefit has roots that go back centuries. Some trace it to cargo-carrying sea captains, who got a cut of a businesses’ profits after literally carrying its goods successfully to a port. In the early 20th century, firms looking for oil used investors’ money to do the hard work of exploring, according to ProPublica. And in exchange for their effort and risk, they received a share of the profits taxed at lower capital-gains rates.
A break for the richest
Critics contend the expertise that fund managers provide is no different from what most people provide at work and should be taxed as such.
It doesn’t hurt that the people benefiting from the policy are also some of the country’s richest, often the 0.01%.
And while some of these beneficiaries, like Warren Buffett, advocate ditching the loophole, it may come as no surprise that many in the industry would prefer to keep carried interest as is.
Billionaires like David Rubenstein of the Carlyle Group have fought changes, as reported by The New Yorker.
Carlye and other private-equity firms are also represented by a trade group pushing the no-change stance, the Washington, DC-based American Investment Council. Here is its stance on the issue:
“As long as one believes that taxing long‐term capital gains at a lower rate is sound tax policy, there is no ‘inequity’ in the current taxation of capital gains attributable to carried interests. Indeed, if Congress denies such tax rates to private equity, it is singling out one group of investors for less favourable treatment than others who do precisely the same thing. If Congress no longer believes having a differential long‐term capital gains rate is fair, it should remove it for everyone, not just private equity investors.”
The issue is divisive, even on Wall Street.
Peter Borish, chief strategist at Quad Group, a New York-based asset-management firm, thinks carried interest should be eliminated.
“The manager is not taking the same risk” as mum-and-pop investors who are investing their own money, Borish said. “If it was all their own money, they would have a legitimate argument.
“If these people are already at the higher end of the spectrum, is it going to change incentives? I don’t think so. And if it does, it’s never politically difficult [for Congress] to say we should lower taxes.”
The issue has picked up steam over the past few years, but nothing has changed since Congress first started hearings on the matter a decade ago, the Tax Policy Center’s Rosenthal said.
“Special-interest lobbyists have stalled any legislation by raising a variety of scope and fairness arguments,” he said.
But it seems clear that whoever wins in November, there will soon be another carried-interest critic living in the White House.