The tax treatment of carried interest is likely to be revisited as efforts to produce a tax reform bill advance, tax professionals said.
Despite being one of the few specific tax breaks repeatedly lambasted by the Trump administration as a “loophole” that would be closed in tax reform, carried interest escaped the chopping block in House Republicans' November 2 tax bill.
“I’m very surprised, shocked actually, that carried interest wasn’t addressed,” Robert Willens of Robert Willens LLC told Tax Analysts November 3.
Currently, carried interest is taxed like capital gains, at 23.8 percent, after accounting for both the 20 percent tax rate on net capital gains and the 3.8 percent net investment income tax. Private equity partners, the primary beneficiaries of carried interest, are organized as passthroughs, and the maximum tax rate on passthrough business income is 25 percent in the Tax Cuts and Jobs Act of 2017 (H.R. 1), which suggests that under the House proposal, repealing carried interest would have had little effect.
That’s a conclusion reached by Steven M. Rosenthal of the Urban-Brookings Tax Policy Center. In the context of the House tax bill, if carried interest were to be treated as ordinary income from a passive business, the income would be taxed at the 25 percent passthrough rate, Rosenthal said. But, if it came from an active business in which the manager materially participated, the 70/30 passthrough guardrail would apply, unless the taxpayer opted to use the facts and circumstances rule.
“I think a manager of private equity could easily create a structure to receive his or her income from a ‘passive’ business or, if from an active business, to exploit the facts and circumstances rule . . . But there are no easy fixes, which could be why the issue was not tackled,” Rosenthal said.
However, according to Willens, because private equity funds engage in “specified service activities” and the “capital percentage” for those properties is set to zero, they wouldn’t get to claim that passthrough business rate on carried interest income. Instead, carried interest income would have been taxed as individual income, which has a top rate of 39.6 percent under the plan.
“By retaining carried interest tax benefits, private equity managers have secured a major tax benefit, one that could not have been replaced by the lower passthrough rate benefit, which is, quite clearly, unavailable to them,” Willens told Tax Analysts.
As recently as September 28, White House officials were still maintaining that the carried interest tax preference should be repealed.
President Trump “remains committed to ending the carried interest deduction,” which is “one of the loopholes we talk about when we talk about getting rid of loopholes,” White House National Economic Council Director Gary Cohn told CNBC’s Squawk Box September 28. The unified tax reform framework released by GOP leaders a day earlier, however, made no mention of carried interest.
And even though repealing carried interest was a mainstay in the administration’s talking points on tax reform that extended back to the presidential campaign, in recent months White House officials have signaled they might back a more nuanced approach.
Treasury Secretary Steven Mnuchin reiterated August 21 that Trump wanted to end the deduction, but suggested that they might want to leave it in place for certain types of investment funds, particularly those for long-term capital investments. That same day, Senate Majority Leader Mitch McConnell, R-Ky., also said the Senate would be looking closely at repealing carried interest.
But not everyone considers carried interest a “loophole” in need of closing. In an October 25 blog post, Americans for Tax Reform said that carried interest should continue to be taxed as capital gains, arguing that ending that tax treatment would reduce savings and investment.
$19 Billion on the Table
By letting carried interest go untouched, House taxwriters are leaving roughly $19 billion in revenue on the table, according to a 2016 Joint Committee on Taxation estimate.
For that reason alone, Donald Marron, also of the Urban-Brookings Tax Policy Center, told Tax Analysts that he expected to see discussions about carried interest resurface before tax reform concludes. “Congressional Republicans will be looking for more revenue raisers,” he said.
Willens similarly predicted that changes to carried interest would show up in the Senate tax bill, which is expected to be released next week.
Rosenthal agreed, saying that even though he doesn’t think repealing the special tax treatment of carried interest would make much difference if private equity managers can simply claim the 25 percent passthrough rate, carried interest has become too politicized to be ignored.
Democratic lawmakers and perhaps even a few Republicans would “make a big to-do” about it, Rosenthal said, before musing, “Maybe this all is orchestrated so that [House Ways and Means Committee Chair Kevin Brady, R-Texas] can give something or appear to give something during markup.”
A White House spokesperson would not specifically say if the Trump administration would continue to seek to repeal carried interest or curtail its applicability. Instead, the spokesperson said that the bill is “clearly an important step toward passing historic reform,” and that the bill would “no doubt change before it reaches the President’s desk.”
In the meantime, the spokesperson said, the White House would continue to push the president’s many tax reform priorities, including among them “eliminating special interest loopholes and deductions.”
Meanwhile, Julia Lawless, a Senate Finance Committee spokeswoman, similarly declined to comment specifically on the status of carried interest in the Senate’s upcoming tax bill, saying instead that all options remained on the table.
Spokespersons for the House Ways and Means Committee did not respond to Tax Analysts’ requests for comment by press time.
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