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Wednesday, December 7, 2022

What is the ‘carry interest’ loophole?

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Congress showed on Wednesday that it has a few more surprises in store for the current session.

In a shocking twist, Senate Leader Chuck Schumer and Senator Joe Manchin announced they had reached an agreement on the Inflation Reduction Act, a scaled-down version of the Build back Better plan that would address everything from healthcare to the environment, especially higher taxes on businesses. To help pay for all that, the agreement also includes taxing some “borne interestprofits by partners in private equity and hedge funds, as well as by venture capital firms.

Closing that loophole could have a noticeable impact on the private equity market. Here’s everything you need to know about carry-rate and what the new deal could mean.

What is carry rate?

Carried interest is a portion of the profits of a private equity, venture capital, or hedge fund that is paid to the fund’s investment manager as an incentive. Essentially, it is a reward for improved performance of a fund or portfolio.

What is the ‘carry interest’ loophole?

While there is nothing wrong with incentives, what has long bothered people about the carry rate is how it is taxed. Fund managers who receive carry interest (who are typically among the wealthiest people in the country) get a tax break on that income.

The loophole treats the income as capital gains, so it’s taxed at a top rate of 20%, rather than the top tax rate of 37%. That’s especially notable for executives like Blackstone Group CEO Stephen A. Schwarzman, who reportedly: earned $610 million in 2020, but was eligible to pay taxes at a similar rate to the average American. (Blackstone has historically refused to discuss Schwarzman’s tax rate, the . narrate New York Times last year that its senior executives are “among the largest individual taxpayers in the country.”)

Typical, says Law360general partners of funds earn a 2% fee and a 20% share of the profits, while limited partners receive 80% of the profits.

The deal struck by Manchin requires the carry rate to be taxed at the higher rate, which proponents say could raise $15 billion the next 10 years.

Why has it lingered for so long?

The gap in the carry rate is a target of many presidents. Obama promised to end it, but failed. Donald Trump did the same, but was unsuccessful. That’s largely because the private equity industry has spent hundreds of millions of dollars on congressional campaigns. Over the past decade, private equity firms and their lobbyists have almost $600 million in campaign donationsaccording to the New York Times. That brings many benefits.

What impact would the bill have on private equity firms?

A survey of 90 fund managers and lawyers by Private Equity International asked in 2021 what closing the loophole would mean for private equity. About 81% of those who replied said yes have a negative influence their operations.

One of the biggest concerns was that it could become less attractive to job applicants (or those currently working in the field), with 43% saying it would significantly harm the profession. Proponents of the loophole also say abolishing it would reduce the chances of creating new investment funds.

Lobby groups for private equity are already speaking out. The American Investment Council wrote in a Tweet on Thursday that “The economy has shrunk for the second quarter in a row – Washington should not push through a new private capital tax that supports small businesses, jobs and pensions across America.”

When will the Senate vote on the bill?

Schumer has promised to vote on the new bill next week.

Will it work?

Nothing is certain with this congress. To avoid a filibuster, it needs 50 votes. With Manchin on board, that gives Democrats 49 votes. Now it comes down to Krysten Sinema, an Arizona Democrat, who has expressed his opposition to the Build Back Better plan — as well as end the carry rate loophole-in the past. So far, Sinema has not issued a statement regarding the Manchin deal.


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