Carried interest is the contractual right received by a private equity or hedge fund manager representing their share of profits or gains from the fund’s investments, which amount is unrelated to any capital invested by the manager. When properly structured, carried interest is taxed at the lower long term capital gains tax rate of 20% (plus 3.8% investment income tax or “NIIT”) instead of the higher ordinary income tax rate of 39.6% (assuming such manager is taxed in the highest federal income tax bracket, plus 3.8% investment income tax or “NIIT”). President Donald Trump vowed on the campaign trail to eliminate what he characterized as the “carried interest loophole” by changing tax laws so that carried interest would be taxed at the ordinary income tax rate; however, the Trump administration has not given any indication as to how they want to deal with this change through legislation and private equity groups and lobbyists have not been shy about continuing to lobby against any such tax change making it into a final law.
On March 27, 2017, the Wall Street Journal reported that Treasury Secretary Steven Mnuchin signaled that the Trump administration wanted hedge funds taxed more heavily, but was still deciding whether or not higher taxes on carried interest could hurt private equity’s ability to drive jobs and economic growth because higher taxes could disincentive investments by pensions, state funds and other investors into infrastructure, real estate and energy. This was an early signal that the Trump administration may have been considering handling the taxation of carried interest differently between hedge fund managers and private equity managers.
In addition on April 26, 2017, the Trump administration released its outline of a tax plan, which was silent on the treatment of any changes to the taxation of carried interest. According to a New York Times article, several tax experts and lawyers have stated that by not mentioning the matter at all, the Trump administration could be signaling that the tax proposal would effectively eliminate the unique taxation of carried interest. However, this does not mean that carried interest necessarily would be taxed at a higher rate because the outline of the tax plan stated that certain “small” pass-through entities, which could include the management entities used by private equity firms and hedge funds, would be subject to a 15% tax rate, which tax rate is lower than the long-term capital gains tax rate of 20%.
However on April 30, 2017, White House Chief of Staff, Reince Priebus, reiterated in an interview that carried interest could be on the chopping block and warned against analysts taking the view that fund managers would continue to benefit from the loophole. Mr. Priebus reiterated President Trump’s campaign message that he wants to get rid of the loophole. It remains to be seen how the Trump administration’s final tax plan will look as well as how lawmakers will change such proposed tax plan prior to some, all or none of it being enacted into law.
In the event that the taxation relating to carried interest is increased to the ordinary income tax rate, fund managers could find their carried interest taxed as high as 43.4% (current rates) or as low as 25% if Trump follows through and slashes ordinary income tax rates and repeals the so-called Obama Care tax (3.8% NIIT).