By: Carlos Micames
As the 2020 elections quickly approach, the Democratic Party is preparing to compete against incumbent Republican President Donald Trump. One of the main issues on the current Democratic platform is the role of taxes in reducing inequality. [1]
Bernie Sanders, a well-known Democrat, brought this issue into the spotlight during his 2016 presidential campaign, when he advocated for raising taxes on the top 1%.[2] Presidential candidate, Elizabeth Warren, has also raised eyebrows with her new “wealth tax,” which proposes a 2% tax on individuals with over $50 million in assets, and an additional 4% for individuals with $1 billion in assets.[3] While the constitutionality of this tax is under discussion, it is one of many tax proposals raised to stifle the effects of income inequality.[4] However, almost all of the presidential candidates are overlooking the carried interest loophole, which could raise billions of dollars in tax revenue if it is closed.[5] Only Elizabeth Warren has proposed closing the carried interest loophole in a Medium post from July 18, 2019, where she compared private equity firms to blood-sucking vampires.[6]
What is the carried interest loophole? Carried interest is income that flows to the general partner (“GP”) of a private equity (“PE”) fund or hedge fund from the fund’s profits and is taxed at the preferential long-term capital gains rate of 23.8% rather than ordinary income rate of 37%.[7] The carried interest distribution typically provides the GP with 20% of the profits.[8] While this may not sound like a significant amount, consider a “small” PE firm with $20 million in profit; that is $4 million in profit for the GP taxed at the preferential capital gains rate. Further, the average hedge fund manager makes from $260,000 to $705,000, with the top five managers equal to a net worth upwards of $55 billion.[9] Some tax lawyers such as Victor Fleischer (who was attacked for years by private equity firms due to his articles expressing opposition to the preferential tax treatment given to carried interest income) argue that because carried interest is like wage and salary income, it should be taxed as ordinary income.[10] However, because carried interest depends on the profitability of the fund’s investments, it is considered “speculative” and is not taxable at the time of grant.[11]
Carried interest is treated as a profits interest under the Tax Code.[12] The tax treatment of a profits interest is generally governed by IRC § 83 and Revenue Procedures 93-27, which state that if a partnership interest qualifies as a profits interest, the service provider is not taxed upon receipt.[13] The IRS distinguishes between a capital interest (taxed as ordinary income) and a profits interest (taxed as capital gains) by analyzing whether the partnership interest is for current assets or for future appreciation and profit of partnership assets.[14] In other words, because carried interest is a promise to receive compensation for services in the future, it is treated as a profits interest and therefore taxed at the preferential capital gains rate.[15]
However, government seems to be taking a greater interest. The Tax Court ruled in Dagres v. Commissioner[16] that carried interest income was compensation for services like those provided by investment bankers or dealers, thus opening the door for carried interest to be taxed at the ordinary income rate.[17] Further, the Treasury Department is also considering scrutinizing hedge fund managers over the use of S corporations to avoid limitations on carried interest.[18] If the Treasury were to characterize carried interest as profit from a service, then it would be taxed as ordinary income rather than capital gains.[19]
Of the nine highest compensated hedge fund managers in 2018, two made over $1 billion and none made less than $370 million, a significant source of income taxed 14% lower than ordinary income.[20] So, if candidates and the US government are so keen on reducing inequality, why don’t they focus their efforts on eliminating the carried interest loophole? The answer is: special interest groups.[21] In the 2018 midterms, hedge fund managers donated $690 million to political groups, with $359 million to Democrats and $312 million to Republicans.[22] In the 2016 election, hedge fund and PE firms contributed $27.6 million to the Clinton campaign compared to $19,000 for the Trump campaign.[23]
Tax reform is likely to be an essential
topic of discussion for the duration of the 2020 presidential campaign. The
concurrent theme of the Democratic party has been reducing inequality by
raising taxes on the wealthy, and there are countless
proposals introduced by presidential candidates.[24] Eliminating the carried
interest loophole would provide a much-needed revenue source for the US
government and alleviate the fears over income inequality that has become the central
topic of discussion in modern politics.[25]
[1] See Zachary Warmbrodt & Rebecca Rainey, Candidates’ views on Income Inequality, Politico (last updated on Jan. 8, 2020), https://www.politico.com/2020-election/candidates-views-on-the-issues/economy/income-inequality/ (summarizing the proposals of each democratic candidate to raise taxes on the wealthy and reduce inequality).
[2] Dan Roberts, ‘No BS in Bernie Sanders’: Unwavering Fight Against the Mega-Rich Still Resonates, THE GUARDIAN (Dec. 18, 2015, 8:00 AM), https://www.theguardian.com/us-news/2015/dec/18/bernie-sanders-campaign-income-inequality-economy-millennials.
[3] See Elizabeth Warren, Ultra-Millionaire Tax, Warren For President (2020), https://elizabethwarren.com/plans/ultra-millionaire-tax (proposing to impose a “billionaire tax” on those with over $50 million in assets).
[4] See Amir El-Sibaie, et al., Tracking the 2020 Presidential Tax Plans, Tax Foundation (November 19, 2020), https://taxfoundation.org/2020-tax-plans/.
[5] See Victor Fleischer, How a Carried Interest Tax Could Raise $180 Billion, N.Y. Times, (calculating how taxing $200 billion of carried interest at ordinary income tax rate could raise an additional $180 billion over 10 years).
[6] See Elizabeth Warren, End Wall Street’s Stranglehold On Our Economy, Medium (Jul. 18, 2019), https://medium.com/@teamwarren/end-wall-streets-stranglehold-on-our-economy-70cf038bac76 (discussing her tax plan to close the carried interest loophole for PE companies).
[7] See What is Carried Interest, and Should it be Taxed as Capital Gain?, Tax Policy Center (last updated on Jan. 25, 2019, 4:25 PM), https://www.taxpolicycenter.org/briefing-book/what-carried-interest-and-should-it-be-taxed-capital-gain.
[8] See id.
[9] See Evan Tarver, Top 5 Highest Paid Hedge Fund Manager, Investopedia (last updated Feb. 19, 2019), https://www.investopedia.com/articles/professionals/100515/top-5-highest-paid-hedge-fund-managers.asp (stating the net worth of the 5 highest hedge fund managers); Ashley Adams-Mott, How Much do Hedge Fund Managers Make? (last updated Aug. 27, 2018), Chron, https://work.chron.com/much-hedge-fund-managers-make-23556.html (elaborating on the different pay structures for large hedge fund managers compared to smaller hedge funds).
[10] See Victor Fleischer, Trump Tax Plan a Triumph of Showmanship Over Common Sense, N.Y. Times (Sept. 29, 2015), https://www.nytimes.com/2015/09/30/business/dealbook/trump-tax-plan-a-triumph-of-showmanship-over-common-sense.html (criticizing the 2017 tax plan for failing to tax carried interest as ordinary income and maintain the carried interest loophole).
[11] See Roger Wohlner, What is Carried Interest and How Does it Work?, TheStreet (last updated on Aug. 21, 2019, 10:45 am), https://www.thestreet.com/investing/funds/what-is-carried-interest-15062756 (explaining that the fund must beat the hurdle, or target return, to earn their carried interest as profit).
[12] 26 CFR § 601.201 (1993); see William R. Welke, et al, Compensating the Service Partner with Partnership Equity: Code § 83 and Other Issues, Kirkland (Mar. 2002), https://www.kirkland.com/-/media/publications/article/2002/03/compensating-the-service-partner-with-partnership/compensating-the-service-partner.pdf (citing I.R.C. § 83) (“[A] service provider recognizes ordinary compensation income equal to the fair market value of ‘property’ received “in connection with the performance of services, less the amount (if any) paid for such property”).
[13] I.R.C. § 83 (2017) (stating that a service provider that receives property with “a substantial risk of forfeiture” is not considered to own the property until it vests); 26 C.F.R. § 601.201 (2019) (distinguishing between a capital interest and profit interest), see Welke, supra note 12,at 3.
[14] See 26 C.F.R. § 601.201 (2019) (“A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest.”) (“A profits interest is a partnership interest other than a capital interest.”)
[15] See Welke, supra note 12,at 3 (“A profits interest seems to be no more a mere ‘unfunded and
unsecured promise to pay money or property in the future’ than a share of common stock.).
[16] Dagres v. Commissioner, 136 TC 263 (2011).
[17]See Laura Saunders, Carried Interest in the Cross Hairs, WSJ (Aug. 6, 2011), https://www.wsj.com/articles/SB10001424053111903885604576486541761322496 (J. Gustafson) (“Neither the contingent nature of [Mr. Dagres’s carried interest] nor its treatment as capital gain makes it any less compensation for services.”); compare Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991) (holding that receipt of a partnership profits interest was not taxable, with In Diamond v. Commissioner, 56 T.C. 530 (1971), aff’d, 492 F.2d 286 (7th Cir. 1974) (holding that receipt of partnership profits interest for services is taxable where the interest value is “readily determinable” and not “speculative”).
[18] See Carried Interest Change Coming in 2020, Treasury Official Says, Pensions and Investment (Nov. 14, 2019; 11:33 am), https://www.pionline.com/regulation/carried-interest-change-coming-2020-treasury-official-says (stating that hedge fund managers have been establishing S corporations to avoid the 3-year holding period required under the 2017 tax law and that the Treasury Department is considering issuing regulations against that).
[19] See Tax Policy Center, supra note, at 6 (finding a disparity between investor profits taxed as capital gains compared to wage and salary income for services treated as ordinary income).
[20] See Tom Maloney, The Best-Paid Hedge Fund Managers Made $7.7 Billion in 2018, Bloomberg (last updated Feb. 15, 2019; 10:13 am), https://www.bloomberg.com/news/articles/2019-02-15/the-10-best-paid-hedge-fund-managers-made-7-7-billion-in-2018 (graphing the compensation and net worth of the top-performing hedge fund managers in 2018).
[21] Hedge Funds, Center for Responsive Politics (2020), https://www.opensecrets.org/industries/indus.php?ind=f2700 (graphing the distribution composition of hedge fund campaign donations by party and presidential candidate).
[22] Alan Zibel, Plutocrat Politics: How Financial Sector Wealth Fuels Political Ad Spending, Public Citizen (May 15, 2019),
Plutocrat Politics: How Financial Sector Wealth Fuels Political Ad Spending(finding that the financial industry constituted the largest source of funding for candidates).
[23] See Hedge Funds, supra, note 21 (finding that Hillary Clinton received much more from hedge fund contributions that Donald Trump); John Carney & Anupreeta Das, Hedge Fund Money Has Vastly Favored Clinton Over Trump, WSJ (Jul. 29, 2016), https://www.wsj.com/articles/hedge-fund-money-has-vastly-favored-clinton-over-trump-1469784601 (finding that hedge fund and PE firms contributed $27.6 million to Clinton’s campaign compared to $19,000 for Donald Trump); Jen Wieczner, Hedge Funds Are Spending More Money Than Ever to Influence Elections, Fortune (Oct. 26, 2016; 4:19 pm), https://fortune.com/2016/10/26/trump-hillary-clinton-hedge-fund-campaign-finance/.
[24] See Amir El-Sibaie, supra note, at 4 (providing details of each candidate’s tax policies).
[25] See Fleischer, supra note, at 5 (calculating the amount of revenue lost by the US government by taxing carried interest at a preferential tax rate of 23.8%).