Diary

Tax Reform That Fosters Prosperity Must Include Carried Interest as Capital Gains

Carried interest should be taxed as capital gains not doubly taxed
Carried interest should be taxed as capital gains not doubly taxed
President Trump ran for president last year on a pledge to reform the tax code. There is no doubt one of the primary legislative initiatives of the new administration will be tax reform. Donald Trump has also pledged to pursue policies that will bring about strong economic prosperity. Tax reform must lower taxes to foster priority, not raise taxes that will discourage investment and hinder job creation.

That tax reform must not include, as some liberal Democrats have called for, an additional federal tax on carried interest. Such a tax would only come at the expense of much needed investment in the economy that will create jobs.

Writing for Americans for Tax Reform, Alexander Hendrie addressed the issue of taxing carried interest, “While supporters of higher taxes on carried interest capital gains say it takes aim at ‘hedge fund guys,’ it would also hurt pension funds, charities, and colleges that depend on these investment partnerships as part of their savings goals. In addition, small businesses would find themselves increasingly shut out from investment money available to them from these partnerships.”

The real issue here is quite simple, carried interest capital gains is not ordinary income. This comes from long term ownership stake in a business, and there is no assurance of making a profit, nor is there a clear rate of return from this kind of investment. There is also the chance of a claw back; when subsequent profits are not achieved, carried interest income is returned.

While hedge funds generally put their money in short term investments that are taxed as the short-term capital gain rate, carried interest from private equity, venture capital, real estate and other partnerships make investment long term in operating business, which are taxed at the long term capital gains rate of 23.8 percent. The key criterion for capital gains treatment is whether the taxpayer has made an entrepreneurial investment – of capital or labor or both – in a capital asset (e.g., a business). Recipients of carried interest meet this test.

Treating carried interest income as capital gains is not a loophole, as some have claimed, and this does not deviate from normal tax rules and principles. Carried interest that is earned from selling a capital asset held for more than one year, for profit, should be taxed as long-term capital gain. Our tax laws have treated carried interest this way for more than 100 years. Changing the tax treatment of carried interest would deprive private equity, venture capital, real estate, and other partnerships of the same long‐term capital gains treatment available to other kinds of businesses that make long‐term investments.

The notion of adding new taxes on carried interest is squarely aimed at private equity, venture capital, real estate, and other businesses that make long-term investments that lead to innovation and job creation. IRS figures show that more than 3.2 million partnerships and more than 22 million business partners could be adversely affected by such a tax increase. Enacting such a tax on carried interest could cause capital gains treatment for similar kinds of long-term investment to be eliminated, undermining our commitment to fostering entrepreneurial risk taking that grows our economy, creates jobs, and leads to overall prosperity.

The concept of prosperity-fostering tax reform, including carried interest as capital gains, would be expected to get strong support from the House Freedom Congress, that includes among its members strong conservative members such as Reps. Mark Meadows (R-NC), Morgan Griffith (R-VA) and Thomas Massie (R-KY). We can hope these leaders in Congress will make the strong case for a strong tax reform will bolster economic prosperity.