The Future of Carried Interest

3/27/2017

April 3, 2017


By Brian J. Hecker, CPA, and Michael C. Tomchewsky, CPA
 

Legislative prognosticators have been saying for the past decade that the days of the so-called carried interest loophole were quickly coming to an end. And they had good reason to believe that: During that period legislators proposed bills to treat carried interest as ordinary income at the rate of almost one per year. Year after year, however, the carried interest tax preference somehow endured.

Fast-forward to the 2016 U.S. presidential election, during which both Hillary Clinton and Donald Trump publicly campaigned on eliminating the carried interest tax preference. At that point, even the most temperate tax practitioners and fund managers resigned themselves to the fact that 2017 might finally be the year that carried interest would be repealed.

But many lose sight of the fact that Congress has the power to write and enact tax law. Specifically, all legislation concerning taxes must originate in the U.S. House of Representatives. In June 2016, Speaker of the House Paul Ryan and Chairman of the House Ways and Means Committee Kevin Brady released a Republican tax agenda called “A Better Way,” which is their blueprint for tax reform. Nowhere in that Republican blueprint is the repeal of carried interest mentioned.

Because both the Republican blueprint and the Trump campaign proposal call for significantly lower marginal income tax rates and continued preferential rates on long-term capital gains and qualified dividends, any subsequent repeal of carried interest may have a negligible effect on private equity managers. In addition, the repeal of carried interest could possibly result in lower effective tax rates for certain hedge fund managers.

The Republican blueprint proposes a maximum 25 percent rate on active business income from a sole proprietorship or pass-through entity. The blueprint also proposes to treat a portion of trade or business income for active participants in pass-through entities as wages taxed at ordinary income rates up to 33 percent. The Trump campaign proposal recommends a 15 percent business rate for “all businesses, both big and small, that want to retain the profits within the business.”1 The open question on Trump’s plan relates to the taxation of pass-through entity owners when the profits are distributed. While uncertainty exists about what types of activities and income would be treated as active business income, it’s possible that a hedge fund manager who is in the business of actively trading securities would meet the definition of generating active business income. A hedge fund that might predominantly realize short-term capital gains could therefore see a lower effective tax rate going forward, regardless of a carried interest repeal.

To add more uncertainty, during his Senate confirmation hearing, Secretary of the Treasury Steven Mnuchin responded to a question by stating, “Our proposed tax reform plan will recommend repealing carried interest on hedge funds.” Some have speculated that because he referred only to hedge funds, Mnuchin intended to make a distinction between carried interest treatment of investor hedge funds (which buy and hold for capital appreciation), trader hedge funds (with active trader business income), private equity funds, and real estate funds.

According to media reports, on March 24, 2017, Mnuchin, speaking at an event in Washington, said that Trump’s goal still is to tax the carried interest that hedge fund managers receive as ordinary income rather than capital gains but that the administration is examining how to make sure that the tax code does not provide an investment disincentive for other types of investors.2

When asked if he thinks tax reform can be enacted by the August recess, Mnuchin said that is the optimistic goal and stated, “and if we don’t, we’ll get it done right afterwards.” Mnuchin added that he “absolutely” thinks tax reform will be done by the fall.3

Interested parties should keep an eye on future legislative developments.


1 Alan Cole, “Details and Analysis of Donald Trump’s Tax Plan, September 2016,” Tax Foundation, Sept. 19, 2016, https://taxfoundation.org/details-analysis-donald-trump-tax-plan-2016; Lynnley Browning, “Trump Confusion on Tax Plan Leads to Wider Estimates of Cost,” Bloomberg, Sept. 19, 2016, https://www.bloomberg.com/politics/articles/2016-09-19/trump-confusion-on-tax-plan-leads-analyst-to-widen-range-of-cost 
2 Naomi Jagoda, “Mnuchin: Trump ‘Ready to Go’ on Tax Reform,” The Hill, March 24, 2017, http://thehill.com/policy/finance/325607-mnuchin-white-house-tax-reform-plan-coming-pretty-soon; Tim Worstall, “Trump’s Treas SecMnuchin – Tax Reform Will Be Easier Than Health Care,” Forbes, March 25, 2017, https://www.forbes.com/sites/timworstall/2017/03/25/trumps-treas-sec-mnuchin-tax-reform-will-be-easier-than-health-care/#68b06f3ffb80
3 Mike Allen, “Steve Mnuchin Previews Tax Reform,” Axios, March 25, 2017, https://www.axios.com/steve-mnuchin-previews-tax-reform-2329415641.html