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New Bill Closes 'Entire' Carried Interest Tax Loophole

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What You Need to Know

  • Wyden's bill closes the entire loophole: private equity managers will no longer be able to defer paying tax for years, if not decades, Wyden said.
  • The Joint Committee on Taxation estimates that the proposed legislation would raise $63 billion over 10 years.
  • The bill ends one of the most indefensible loopholes in the tax code allowing wealthy private equity managers to be taxed at lower rates, Wyden said.

Senate Finance Committee Chairman Ron Wyden, D-Ore., and Sen. Sheldon Whitehouse, D-R.I., have introduced legislation to close the carried interest loophole, ending a tax dodge for wealthy private equity and hedge fund managers.

Presented Thursday, Wyden and Whithouse’s bill would close the entire carried interest loophole — including the recharacterization of income from wage-like income to lower-taxed investment income and the deferral of tax payments.

“One of the most indefensible loopholes in the tax code allows wealthy private equity managers to be taxed at lower rates than nurses treating COVID patients and avoid paying any tax year after year after year. This is an issue of fairness,” Wyden said in a statement.

“Importantly, my bill closes the entire loophole — private equity managers will no longer be able to defer paying tax for years, if not decades. Nurses treating COVID patients can’t defer paying taxes for years — neither should the private equity managers,” he explained.

Previously introduced bills, according to Wyden, only “address half of the problem — recharacterization of income.”

The Joint Committee on Taxation estimates that Wyden’s bill would raise $63 billion over 10 years, whereas previously introduced bills that did not address the deferral of tax payments would raise just $15.6 billion over 10 years.

“Americans have had enough of hedge fund tycoons using this special carve out to pay lower tax rates than their drivers,” Whitehouse said in a statement. “We need to rebuild our tax code to guard against the ultra-rich and corporations scheming to avoid paying their fair share. Our bill is a good place to start.”

To prevent the recharacterization of income, fund managers would be required to recognize annual compensation that would be taxed at ordinary income rates and subject to self-employment taxes, the two senators say.

“Annual compensation would be determined using the estimated forgone interest on an implicit interest-free loan from investors to the fund manager at a prescribed interest rate,” according to a summary of the bill.

To end the deferral of tax payments, the bill treats transactions between fund managers and investors as occurring outside the partnership, decoupling compensation from future sales of investments and ensuring the value of the fund manager’s carried interest is taxed from the outset, the lawmakers state.

“Under current law, the fund manager’s carried interest is taxed as income from the partnership, which allows the deferral of tax payments until future investment sales,” the lawmakers noted.

To account for the recharacterization to wage-like income and avoid double taxation, the fund manager would also realize a long-term capital loss equivalent to the annual compensation, which could offset the fund manager’s future long-term capital gain from sale of an investment.

“As with all capital losses, the loss could be used to offset long-term capital gains or carried forward,” the bill states.

The lawmakers provided this example: If the fund manager receives a 20% carried interest in exchange for managing investors’ capital of $100 million, and the prescribed interest rate for the tax year is 14%, the fund manager would pay the top ordinary income tax rate of 40.8% tax on $2.8 million in deemed compensation.

Drew Maloney, president and CEO of the American Investment Council, a lobbying group for the private equity industry, said Thursday in a statement shared with ThinkAdvisor that “In the middle of economic uncertainty during the pandemic, the private equity industry helped over 11 million workers keep their jobs, helped over 13,000 small business stay open, fueled sustainable energy projects, and ensured thousands of public servants have secure retirements. Instead of dusting off old proposals that single out certain taxpayers, policymakers should encourage more private investment across America.”

Wyden also introduced the same day, The Modernization of Derivatives Tax Act, legislation that Wyden said closes loopholes that allow wealthy investors to use derivatives contracts to not pay tax on the underlying investments.

The bill would require investors to annually pay tax on their gains or deduct their losses.

“Gains would be taxed at ordinary income rates, which is already the case for banks and securities dealers with respect to derivatives,” Wyden explained.

The bill would also repeal nine tax code sections and revise many others, making the code less complex.

(Photo of Sen. Ron Wyden: Bloomberg)