What You Need to Know
- Supporters of Biden's plan include those who want to close this tax loophole for private equity and hedge fund managers.
- The plan could decrease fund managers’ incentives to maximize long-term profits.
- Fund managers might change their valuation methods or impose other fees, which would draw SEC scrutiny.
The Biden administration’s proposal to tax carried interest at a higher rate (like the ill-fated proposal from the Trump administration) could create Securities and Exchange Commission disclosure issues for private equity and other fund managers by altering the economic structures and incentives baked into many fund relationships.
Currently, the portion of an investment fund’s returns that is paid to fund managers or general partners as compensation in the form of a partnership interest (carried interest, performance allocation or promote) is generally taxed at a lower capital gains rate rather than at a higher ordinary income tax rate. The Biden proposal would in many cases eliminate the availability of the lower capital gains tax rate for a partner’s share of income on an “investment services partnership interest” (“ISPI”) and on the sale of an ISPI if the partner’s taxable income exceeds $400,000.
In announcing the proposal in April, President Joe Biden was clear about his objectives: to ensure that “hedge fund partners will pay ordinary income rates on their income just like every other worker.”
The political debate over the topic pits those who see it as an opportunity to “close yet another tax loophole to allow wealthy private equity and hedge fund managers to avoid paying their fair share of income taxes” against those who argue that the proposal would eliminate an incentive for people to “remain invested in businesses that keep this economy moving.” Or, as one industry blog post put it, the proposed change “would reduce long-term investment and entrepreneurship by making short term economic activity relatively more attractive.”
Beyond the political points to be scored for taxing the wealthy or punishing long-term entrepreneurial risk-taking, imposing higher taxes on carried interest may have SEC-related implications for the private equity and fund management industry.
SEC Scrutiny of Carried Interest
The regulatory issues around carried interest — like the carried interest concept itself — are not new. According to FINRA, the term “carried interest” dates back to the 16th century, when ship captains were routinely paid 20% of profits generated by the cargo they “carried.”
Because fund managers sometimes receive a large portion of their compensation in the form of a share of the profits after return of capital and any preferred returns to limited partners, the SEC has frequently focused on potential disclosure issues around carried interest.