May 30, 2023

What is the Carried Interest Loophole, and Why Is It So Difficult to Close It?

The U.S. tax code is riddled with tax expenditures, better known as "tax breaks," including loopholes, deductions, exemptions, credits, and preferential rates. Among the most controversial is the loophole for carried interest. Here we examine the treatment of carried interest in the U.S. tax system and its implications for the federal budget.

What Is Carried Interest?

Carried interest refers to compensation earned by investment managers on the performance of their fund. Generally, investment managers receive two types of compensation for their services:

  • A management fee, tied to some percentage of assets they’re managing
  • Carried interest, tied to some percentage of the profits generated by those assets

While the management fee is taxed as ordinary income for the investment manager, taxation of carried interest can be deferred until profits are realized; those profits are treated as investment income, thereby enjoying a lower tax rate. For example, a common structure for carried interest may involve the investment manager earning 20 percent on the fund’s profits. The “interest” refers to that percentage of profit, which is “carried” over to the fund manager.

Proponents of carried interest argue that the investment strategies, expertise, and oversight provided by fund managers significantly bolster profits for a wide variety of investment vehicles and thus, carried interest should be considered investment income and taxed as such. Critics however argue that carried interest is compensation for a service and should therefore be taxed at the rate of ordinary income.

How Big is the Carried Interest Loophole?

According to the Tax Policy Center, in 2019, private equity funds managed $4.1 trillion, with carried interest acting as the primary source of income for partners. Although such earnings may put them in high tax brackets, carried interest is typically treated as long-term capital gains, meaning it is taxed at 20 percent as opposed to ordinary income, which would be subject to a top rate of 37 percent. To put it in further perspective, a married couple filling jointly would exceed the 20 percent marginal tax rate of the average general partner with an annual income of roughly $84,000.

The tax rate for carried interest is less than the highest marginal tax rate

That preferential tax treatment reduces federal revenues, putting pressure on the federal budget.

Potential Changes to Carried Interest

Several proposals have been made in the past to reform the treatment of carried interest. The Tax Cuts and Jobs Act of 2017 attempted to diminish the tax preference for carried interest by extending the number of years an asset must be held before it is considered a long-term capital gain from one year to three. However, the effect of that provision is limited given that many private equity firms tend to hold assets for longer than five years.

Early drafts of the Inflation Reduction Act of 2022 contained a provision to end the lower taxation of carried interest, but that provision was ultimately removed in the final version of the Senate bill. According to the Joint Committee on Taxation, adjusting carried interest tax laws, as outlined by the Ending the Carried Interest Loophole Act, could generate $63 billion over 10 years.

Carried Interest is one of hundreds of tax expenditures in the code, but it draws scrutiny. Many economists believe it would help the economy to do away most tax breaks, including carried interest, to make the code more efficient and reduce the deficit. Reforming the tax code by cleaning up tax expenditures could help promote economic growth, make the country’s fiscal outlook more sustainable, reduce the complexity and burden of compliance, and increase the system’s transparency and fairness by treating individuals and businesses in similar circumstances more equally.

Related: How Do Marginal Income Tax Rates Work — and What if We Increased Them?

Image credit: Spencer Platt/Getty Images

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