In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses the carried interest rules, and why they may go away thanks to a new proposal, and what that means for investors.
Senators Ron Wyden and Sheldon Whitehouse, two Democrats have introduced legislation that would eliminate a tax break on the private equity world. The carried interest rule allows fund managers to pay less taxes on earnings than if it were regular income. Further, the bill would no longer allow tax payment deferrals.
What is Carried Interest?
Carried interest is defined as “a share of any profits that the general partners of private equity and hedge funds receive as compensation regardless of whether they contribute any initial funds.” The fund manager receives compensation for “investment management services.” That compensation can be deferred until the investment is sold, which may be many years later. Plus, it can then be taxed at the much lower capital gains tax rate.
As with any tax proposal, it’s all about raising money. Supposedly, the new laws would raise over $60 billion over ten years. That’s four times as much as similar, although incomplete, proposals have suggested.
Those bills only addressed the re-characterization of income (from ordinary income to capital gains). This proposal eliminates the tax deferral aspect of carried interest. No longer can these fund managers avoid taxes for years, and, in some cases, decades.
Learn more about Carried Interest
What This Bill Does
The benefit of carried interest is twofold. First, is the type of tax you have to pay. Obviously, anyone wants to lessen the tax bill annually. By treating this income as capital gains, you avoid paying the highest tax in the nation. Secondly, when you pay the tax is crucial. Since the investment hasn’t been sold, and there is no gains realized, you don’t owe tax until you sell the asset. All this money sits in the investment for years.
What Senators Wyden and Whitehouse want to do is eliminate both of these advantages for carried interest. Therefore, you will pay higher taxes and pay them annually. The crazy thing is that you might be stuck with a large tax bill, for an investment that hasn’t paid off yet. Essentially, you are paying taxes on the money invested in the fund. Obviously, the equities industry is up in arms about this proposal.
There is a workaround the carried interest rule. They can restructure the carried interest as a separate class (Class B) with a separate economic return that will include some investment for the unit but higher returns on a super capital event. Basically, you give the limited partners their return of capital. If there’s a 10% rate of return, the Class B units will get a percentage of the profits. It’s re-categorizing the carried interest as an LP interest to get the capital gains.
Conclusion
In the end, there will be a lot of back and forth to see if this bill gets passed. There is support to tax these fund managers, but, as always, there is opposition. Stay tuned as Adam will keep you abreast of the situation in future podcasts.
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