'Loophole for billionaires' stays in code, undermines tax reform

'Loophole for billionaires' stays in code, undermines tax reform
© Getty Images

Members of CFA Institute who participated in a survey said they overwhelmingly believe that carried interest (CI), which is part of the incentive compensation paid to private investment fund managers, should be taxed as ordinary income. 

In the survey, approximately 68 percent of investment professionals said CI should be part of ordinary income for tax purposes, while just 25 percent said such payments should continue to be taxed as capital gains. Another 6 percent of respondents felt other tax regimes were merited. 

ADVERTISEMENT

CI is a share of profits partners in an investment fund pay to investment managers to encourage improved performance. Typically, CI amounts to 20 percent to 25 percent of a fund’s annual profit, which goes on top of the smaller management fee.

 

Over the years, the private fund industry has been allowed to pay tax on this incentive portion of the compensation at lower, capital gains rates. This has been a point of controversy among investors, policymakers and even some fund managers who believe that carried interests are simply investment management fees and should be treated like all other compensation for services, as ordinary income.

The removal of this so called “loophole for billionaires” was featured as part of the recent U.S. presidential election campaign. According to the New York Times:

“During the presidential campaign, Mr. Trump called for closing the loophole. He called hedge fund managers ‘paper pushers’ who were 'getting away with murder' partly because of measures including the carried-interest provision that he said allowed them to shield their wealth and to minimize their tax burdens."

In similar vein, CFA survey respondents called capital gains treatment “gimmicky” and “aristocratic.”  

Individual taxpayers feel even more strident about the treatment of carried interests for fund managers, whom they see as all-too-powerful lobbyists in Washington. Undeniably, their efforts have allowed many of the most highly compensated individuals in the finance industry to shelter ordinary income from full taxation.

If not for the capital gains treatment of carried interests, the tax bill might have represented a meaningful step toward eliminating special interests in the tax code. Keeping the CI intact is all the more puzzling because changing it represented low-hanging fruit from a regulatory perspective.  

Meanwhile, a small minority of survey respondents expressed sentiments about alternative approaches to taxing CI compensation. Some investors favored a bifurcated approach as in, “the original amount (base) should be taxed at ordinary income during the year in which it was earned, then returns off of that base amount taxed at capital gains.” 

Other investors advocated for a blended rate. Still other investors felt that any differential in the capital gains rate and the ordinary income rate was unfair: “Capital gains and ordinary income need to be taxed at the same rates. Passive-income aristocracies are contrary to our national identity — we fought a war for independence over it,” one respondent wrote.

Perhaps even more confounding were plans in earlier versions of the bill to remove one of the few investment tax-planning tools available to small investors at the same time private fund managers were allowed to keep their tax advantages.

In the end, though, Congress relented and allowed small investors to continue to designate which shares of a stock position they want to sell to minimize tax liability or offset other gains. If not for that change, the decision to allow CI would have been all the more troubling. 

Despite its hot-button status during the presidential election, the tax treatment of carried interest has dodged a major bullet. According to the sentiments of investment professionals, that’s a shame, both for tax fairness and for appearances sake.

Kurt Schacht is the managing director of standards & advocacy at the CFA Institute, a global association of investment professionals with more than 145,000 members.