Carried Interest

As widely reviled tax breaks go, few can match the one known as carried interest. It lets some high-earning managers in private equity, venture capital and other investment funds pay a lower tax rate on their income than most working Americans. Carried interest hinges on the idea that a partner in a long-term investment whose contribution isn’t money but management skill should be regarded as a fellow entrepreneur. It’s a notion that dates back to the way Renaissance merchants paid ship captains for profitable journeys. To those who receive the break, carried interest is the holy grail of compensation. To critics, it’s a symbol of how the tax system can exacerbate income inequality.

In the U.S., the carried-interest benefit allows managers of partnerships, such as private-equity and venture-capital firms, to pay taxes on investment profits at the long-term capital gains rate of 20 percent, versus a top rate on ordinary income of 37 percent. (A 3.8 percent surcharge tied to Obamacare is added to both rates.) During the U.S. presidential campaign, Donald Trump said the tax break was a loophole that let rich managers “get away with murder.” Yet the new tax law he signed in December 2017 did not end the tax break. Instead, Congress decided that investment managers must hold assets for at least three years, rather than the previous one-year requirement, to qualify for the lower rate. By one estimate, that would have affected about a quarter of private-equity deals since 2000. When carried interest is paid to a corporation rather than an individual, however, the three-year holding period doesn’t apply. That led many investment managers in early 2018 to hurriedly set up corporate entities to continue receiving their carried-interest payments at the lower tax rate — and to a quick pledge by Steven Mnuchin, the U.S. Treasury secretary, to issue guidelines to close the loophole. Other countries have eliminated or tightened their carried-interest tax breaks. In Sweden, a court in 2017 upheld the government’s plan to tax income earned by private-equity managers from investments as salary instead of capital gains. Britain in 2016 began taxing carried interest at a higher individual rate of up to 45 percent on investments held for fewer than 40 months. Germany has a hybrid system: 60 percent of carried interest is taxed at the highest individual rate and the rest is tax free.