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The carried interest loophole may significantly change…

Update 8/9/22: The attempt to add a provision to remove the carried interest loophole came to a halt during discussions leading up to a final vote. Senator Krysten Sinema’s support for the Inflation Reduction Act was contingent upon removing the provision.

A carried interest is the share of the profits from private equity and hedge funds an investment manager receives as compensation.  Beginning in 2018, the Tax Cuts and Jobs Act (TCJA) requires a three-year holding period for long-term capital gain tax treatment on carried interest income.  Before TCJA, it was a one-year holding period.

The loophole taxes carried interest income at long-term capital gain rates versus ordinary income rates.  The top long-term capital gains rate is 23.8% versus the total ordinary rate of 37%.  Closing the loophole would impose the same tax rate on fund managers compared to other professionals.

Why has this loophole remained? Private equity firms and hedge funds spent $627 million on political campaigns and lobbying during the 2019-2020 election cycle according to an analysis by Americans for Financial Reform.  This is an increase from about $500 million in the 2015-2016 election cycle.

On Wednesday, Senate Majority Leader, Charles Schumer, and Senator Joe Manchin reached an agreement on the Inflation Reduction Act (the Act). The agreement includes reform to carried interest taxation. Under the Act, the general carried interest holding period would be extended to 5 years, making it more difficult to receive the benefit of the lower rate.  The three-year holding period would remain for taxpayers with an adjusted gross income of less than $400,000.

“Our tax code should not favor red state or blue state elites with loopholes like SALT and should focus more on closing unfair loopholes like carried interest. Through the enforcement of a fair tax code, we can use the revenue to cut the deficit and lower the cost of healthcare for working families and small businesses,” Manchin said in a statement.

The American Investment Council, a lobbying, advocacy, and research organization for private equity, wrote on Thursday, “The Economy just shrank for the 2nd quarter in a row – Washington should not move forward with a new tax on private capital that supports small businesses, jobs, and pension across America.”

The Senate is expected to vote on the bill next week.

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