How the Carried-Interest Loophole Survived Tax Reform

President Trump vowed on the campaign trail to get rid of the controversial provision. But neither GOP tax bill fully does.

Private equity firms like Blackstone Group LP in New York saw a favored tax break preserved in the Republican tax bill.
AP Photo/Mary Altaffer
Dec. 2, 2017, 1:18 p.m.

Senate GOP leadership locked up the necessary votes and passed its sweeping tax-overhaul bill early Saturday morning, and despite President Trump’s campaign vows, the CEOs of some private-equity firms are coming out ahead.

The Senate bill, like its House counterpart passed earlier this month, contains a provision that would extend the holding period for investments to qualify for the carried-interest tax break, a move some analysts say would be ineffective and a far cry from the administration’s calls to fully eliminate the break.

Carried interest is the profit some investment fund managers receive as payment. It is taxed at the capital-gains rate of 20 percent—plus a 3.8 percent investment tax related to the Affordable Care Act—compared to the higher individual tax rate, which currently has a top bracket of 39.6 percent.

The break generally benefits the heads of private-equity firms, real-estate partnerships, and venture-capital firms. Critics argue that carried interest is a loophole that allows fund managers to divert their substantial labor income to a lower investment-tax rate. Proponents of the current system disagree—and have lobbied hard to maintain it.

The change in the tax bills would require that any asset be held for three years or longer before a taxpayer could claim the carried-interest provision. The current holding period is one year. House Ways and Means Committee Chairman Kevin Brady said earlier this month that the provision would ensure that hedge funds don’t benefit from the break, leaving it only to long-term real-estate partnerships.

But some analysts say the provision won’t have much of an impact on those using the break.

“That’s not going to have any effect on carried interest,” said Robert Willens, a New York-based tax expert whose clients include hedge funds and private-equity firms. “The private-equity partners who benefit most from carried interest are not going to be penalized on account of that increase in the holding period because they inevitably hold their investment for longer than three years already.”

The numbers bear out that point. A report by the research firm Preqin finds that the average investment holding period for a private-equity firm was 5.9 years in 2014. Real-estate firms tend to hold their assets longer than three years as well.

Secondly, Willens and others argue that hedge-fund managers wouldn’t be affected by the rule change either, since most of those firms buy and sell their assets sooner than one year, the current holding period to allow carried interest. Thus, their short-term capital gains are taxed at the ordinary income rate.

Brady defended the provision and said that there isn’t any appetite on the House side to revisit carried-interest treatment when lawmakers reconcile the House and Senate versions of the tax bill.

“We believe the three-year holding period addresses a couple things: One, it makes sure that there is skin in the game and capital at risk, and that these actors are holding these projects, that they are longer-term gains,” Brady told reporters Thursday.

The holding-period extension in the House and Senate tax bills won’t raise much money—only $1.2 billion over a decade, according to the Joint Committee on Taxation. The JCT has said fully eliminating the carried interest would bring in about $17 billion over a decade, but some analysts say that number could be much higher.

Throughout his campaign, Trump struck a populist tone as he railed against carried interest, calling for its elimination and saying it was a giveaway to Wall Street players, who were “getting away with murder.” Just two months ago, White House economic adviser Gary Cohn said on CNBC: “The president remains committed to ending the carried-interest deduction.”

But advisers close to Trump rallied to back the three-year holding period. Andrew Surabian, a former strategist for Steve Bannon and currently an adviser to the pro-Trump Great America Alliance, wrote Thursday in The Hill that the three-year holding period is a win for Americans and a fix to the carried-interest loophole.

Corners of the financial industry have fought hard to preserve the break, and there has been pressure on lawmakers. When asked why the Senate bill didn’t fully repeal carried interest, Senate Finance Chairman Orrin Hatch simply said, “the votes.” Sen. Susan Collins sought to include an amendment to the tax package that would have eliminated the carried-interest loophole in order to pay for an expanded child tax credit, but her measure did not get a vote.

The American Investment Council, a Washington trade association representing private-equity firms, has lobbied to preserve the carried-interest provision, arguing that raising taxes on private equity would remove an incentive for entrepreneurial risk taking. Through 2017, the group has reported some $970,000 in lobbying expenditures for the first three quarters of the year, including on issues related to the tax-overhaul bills, according to the Center for Responsive Politics.

Steven Rosenthal, senior fellow at the Tax Policy Center, also said the three-year holding period would have little effect on private equity, calling the provision “ineffective.”

“The Congress is not interested in solving the carried-interest problem; they’re interested in giving the appearance of solving the carried-interest problem,” he said.

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