How the Inflation Reduction Act Failed to Close a Billion Dollar Tax Loophole

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  • Long-term capital gains tax rates are preferential lower rates paid on investment income in the United States.
  • Private equity firms earn money by charging the first 20% of gains made on an investment.
  • Carried interest allows private equity principals to treat income from their firms as long-term capital gains instead of ordinary income.

Sen. Kyrsten Sinema (D-AZ) is an outspoken proponent of the carried interest rule.

On Aug. 16, President Biden signed into law the Inflation Reduction Act following a highly contested run through the Senate. While the bill introduced measures to reduce the federal deficit, fight climate change, and allow Medicare to negotiate drug prices, more telling is what was left out of the broad bill. By failing to outlaw the so-called carried interest loophole, Congress has continued a long tradition of allowing private equity managers to skip out on paying their fair share in taxes.

Ordinary income vs. LTCG rates

In the United States, the federal government collects money by taxing income. While most of this income is treated as ordinary income, and taxed at one set of rates, investment income is treated preferentially and is taxed at a lower set of rates.

When most Americans think about taxes, they think about ordinary income tax. Ordinary income is broadly defined as compensation for employment. Wages, tips, salaries, commissions, and bonuses all fall into this category. In the United States, taxpayers can typically expect to pay a minimum of 10% and a maximum of 37% in taxes on ordinary income.

The United States tax code also offers a second set of tax rates on earnings from investments. These so-called long-term capital gains rates are lower than ordinary income rates. Investors can expect to pay as low as 0% or as high as 20% in taxes for earnings deemed long-term capital gains. The idea is that investments in the US economy are something to be encouraged, and should therefore be taxed at preferential rates.

Private equity 101

When it comes to private equity investing, the name informs the meaning. Private equity involves investing in privately held companies. A private equity investor seeks to make a winner of a stagnating company, usually by means of replacing leadership, laying off workers, or otherwise restructuring the company.

For our discussion of the carried interest loophole, it is important to understand how private equity firms are compensated. Typically, a private equity firm will charge a management fee and a performance fee. The management fee usually hovers around 2% annually for the management of assets. The performance fee is where real money is to be made, as a private equity firm may charge 20% or more of the gains on the sale of a successful investment. These favorable payout terms are one reason private equity managers are highly compensated, sometimes in the billions of dollars per year.

The carried interest loophole

The carried interest loophole allows private equity firm managers, sometimes compensated in the millions or billions of dollars, to treat their income as long-term capital gains. This treatment caps their tax at a maximum rate of 20%, even though their earnings were a form of employment compensation. The idea behind the loophole is that private equity compensation is the product of investment, so should be treated as a long-term investment for tax purposes.

A storied history

The carried interest loophole has been around since the 1950s, and its most recent brush with death isn't its first.

In 2010, under the Obama administration, Democrats attempted to close the carried interest loophole. The measure passed the House but stalled out in the Senate on the backs of campaign donations from the private equity sector. The 2016 presidential campaign saw future president Donald Trump rally against the loophole. After getting into office, however, the appetite of Congress was no longer for getting rid of the loophole and efforts stalled once again.

Which brings us to the Inflation Reduction Act of 2022, which originally had provisions to close the loophole. In a deliberation which saw moderate Democratic Senators Joe Manchin (D-WV) and Kyrsten Sinema (D-AZ) holding much of the power to pass the bill through a split congress, the loophole was ditched so the rest of the bill would survive. The future of the provision is uncertain, but with Senator Kyrsten Sinema on the side of private equity, the loophole will live to fight another day.

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