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March 9, 2017

Possible Changes for the Tax Treatment of Carried Interest Under President Trump

There is a lot of uncertainty and lack of detail on what could legislatively be implemented around Congress and President Trump’s tax policy proposals. We outlined features of proposals on individual and corporate tax, but additional proposals and ideas have been discussed, including changes to the tax treatment of carried interest for certain real estate investors and investment managers.

What is Carried Interest?

In general, carried interest is a form of income received by professional private equity or hedge investment fund managers or certain real estate investors for enhancing the performance of an investment fund by actively managing the assets to maximize that fund’s return.  The typical entity structure is usually comprised of a general partnership, which is owned by the people who actively manage the investment fund.  This general partnership owns the private equity fund itself, which is owned by other passive limited partners.  The managers contribute their own capital into the equity fund, which would be the amount they ultimately stand to lose personally, while additional contributions from limited partners are also invested into that same fund.  The managers actively manage all of the contributions into the fund and receive a fee for their services, which generally range from 1-2%.  In addition to this management fee, these managers are also paid a certain percentage of the return on the funds’ assets over a hurdle rate, which is the amount classified as the carried interest.

Current Taxation of Carried Interest and the Proposed Reform

Carried interest is currently taxed at preferential capital gains rates and has drawn the ire of President Donald Trump and others as being unfair to wage earners and suggested carried interest should be taxed at the same ordinary rates as wages.

Preferential Treatment of Carried Interest

The general argument made by managers and others advocating to keep carried interest taxed as capital gains is that investment managers assume entrepreneurial risk in contributing their own capital into the fund.  Since the carried interest is tied to performance, it is treated like an investment and subjected to the lower capital gains tax rate. While there are no further details on what form of legislation could be specifically drafted to address issues like carried interest at the moment, there are some arguments that have laid out why carried interest should no longer have this preferential treatment.

General Return on Investment Share vs Labor Share

Some experts have argued that this carried interest should really be broken down into two separate subcategories, the general partner return on investment share and the general partner return on labor share.  The general return on investment share is the amount that manager stands to gain or lose from their own contributed capital.  In contrast, the return on labor share is the portion of carried interest that is a return on the management of other contributed assets into the fund by people such as the limited partners.  This is similar to how the IRS would see as “sweat equity” in the startup world, where an owner who performs services is then given an interest in the company.  Similarly, the professional investment manager is gaining more interest in the fund by actively managing the assets to a return and receiving the returns as a form of income.  Since the manager does not assume the risk personally for these other contributed funds managed, any return they receive on this is really more a return on labor or service income and should be taxed at ordinary income rates.

It is not known whether President Trump’s possible changes to the taxation of carried interest would survive the many iterations of legislation and compromises that are likely to take place in Congress.  Paul Ryan has recently mentioned that Congress would like to address comprehensive tax reform in the spring.  We will stay tuned for any further developments if legislation becomes more imminent.  For additional information, please contact an Anders advisor.

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