Senator Wyden Introduces new legislation to close the Carried Interest loophole
On August 5, 2021, U.S. Senate Finance Committee Chairman Ron Wyden and U.S. Senate Finance Committee Member Sheldon Whitehouse introduced legislation called “Ending the Carried Interest Loophole Act.” While this legislation is similar to previous proposals introduced by Chairman Wyden, this bill has a better chance of passing given the Democratic party’s control of both chambers of Congress. Though the bill’s “carried interest” reference highlights the impact on private equity where that term is commonly used, it equally impacts hedge fund managers’ and sponsors’ “profits interests”. The Joint Committee on Taxation estimates that the bill would raise $63 billion over ten years.
Under current law, a partnership can issue or allocate “profits interests” to a fund manager without current tax impact, which would otherwise be taxed as ordinary income. This treatment allows for the deferral of tax payments and applicable tax rates until the sale of investments tied to that profits interest. When the fund later recognizes capital gain, the fund manager’s share of the gain is recognized and taxed in that year, which also commonly results in application of a lower long-term tax rate.
The proposed bill would require a fund manager who receives a “profits interests” to recognize annually a “deemed compensation amount” as ordinary income, including application of self-employment taxes regardless of whether the investment partnership recognizes income or gain or when the fund manager receives a distribution in respect of their profits interest. To account for the re-characterization to wage-like income and to avoid double taxation, the fund manager would also realize a long-term capital loss equivalent to the annual compensation. This could offset the fund manager’s future long-term capital gain from the disposition of an investment.
For example, if a fund manager receives a 20% carried interest (or incentive allocation) in exchange for managing investors’ capital of $100 million, and the interest rate for the tax year is 14%, the fund manager would pay the top ordinary income tax rate of 40.8% on $2.8 million in deemed compensation.
To prepare for the changes that may lie ahead, fund managers should contact their tax accountant to understand and plan for their unique tax situations, including the treatment of carried interest allocations, tax consequences of transactions, investment structuring and other consequences.
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