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Biden's Carried Interest Tax Proposal Could Put Fund Managers in SEC's Sights

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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.

In particular, because the calculation of carried interest depends on the valuation of illiquid assets, the SEC has worried for years about the possibility that fund advisors might inflate the value of assets used to calculate carried interest.

Most recently, in a risk alert last year, the SEC’s Office of Compliance Inspections and Examinations noted that SEC staff had “observed private fund advisors that did not value client assets in accordance with their valuation processes … [leading] to overcharging management fees and carried interest because such fees were based on inappropriately overvalued holdings.”

Implications of a Carried Interest Tax Hike

Raising taxes on carried interest may give fund managers incentive to employ valuation techniques that minimize or defer the tax or that attempt to recoup income lost as a result of the higher taxes.

The SEC has also expressed concern that as fund managers’ ability to collect carried interest declines (as would be the case with the proposed tax increase), fund managers “may attempt to make up that shortfall in revenue by collecting additional fees or shifting expenses to their funds.”

Similarly, the SEC has criticized fund managers for failing to adequately disclose the terms of loans between a fund and the general partner designed to defer carried interest taxes. The proposed increase would presumably create an incentive for more such deferral transactions. When the SEC thinks fund managers have failed to adequately disclose these types of alternate sources of revenue or deferral, the SEC has not hesitated to bring enforcement actions.

Like 16th century ship captains and their investors, fund managers who receive carried interest compensation have a financial interest in making long-term profits for their fund investors. By increasing taxes on carried interest, the Biden proposal would decrease managers’ incentives to maximize such long-term profits.

For those fund managers inclined to employ new valuation techniques, impose fund expenses, or engage in transactions between the fund and the manager to recoup compensation lost as a result of increased carried interest taxes, the SEC will be scrutinizing disclosures for shortcomings.