At a conference in September, Treasury Secretary Steven Mnuchin broached a sensitive topic for thousands of wealthy investors: the fate of the preferential tax treatment many of them receive from running a hedge fund or private equity fund.
It turns out the industry didn’t have much to worry about. The tax-overhaul plan unveiled by Republicans in the House last week leaves the special tax treatment in place.
At issue is how much private equity fund managers and other investors should be taxed on their profits. These managers typically take a fee, 2 percent, from investors and claim a share of whatever profits they generate, generally 20 percent. Under the current tax code, the 20 percent in profits — or carried interest — these managers pocket is treated as a long-term capital gain and taxed at a rate of 23.8 percent. That is well below the 39.6 percent rate they could otherwise be required to pay if the money were treated as ordinary income.
The preferential tax treatment has sparked a multiyear battle between some of the most influential forces on Wall Street and Democrats who say the rule is unfair. In 2010, Stephen A. Schwarzman, chief executive of Blackstone Group, one of the world’s largest private equity firms, compared efforts to increase the carried-interest rate to war. “It’s like when Hitler invaded Poland in 1939,” he said.
Schwarzman, who has been a close adviser to Trump, later apologized.
Critics argue that these wealthy financiers should be paying more. The preferential tax treatment gives the wealthy an unfair advantage and deepens the divide between the rich and poor, they say. “If you thought that this tax plan would reflect populist goals, it was very strange that repealing carried interest is not in it,” said Matt Gardner, executive director of the Institute on Taxation and Economic Policy.
At stake is potentially billions of dollars. Congress’s Joint Committee on Taxation has estimated that changing the treatment of carried interest could raise about $16 billion over the next decade. Academics who have studied the issue say the figure could be much higher, $180 billion.
The investors with the most to lose are real estate developers, private equity managers and venture capitalists, tax experts say. Real estate investors can pool their money into funds to finance large projects. Private equity funds make their money by buying struggling companies cheap, turning them around and then selling them for a profit. Venture capitalists pour money into start-ups or small companies looking for cash.
“The real estate industry pioneered the [carried-interest break] and private equity made it a refined art form,” said Steve Rosenthal, a senior fellow at the nonpartisan Tax Policy Center in Washington.
Industry officials say it has become essential. The special tax treatment encourages venture capitalists, for example, to wager on a start-up that could create jobs and opportunities for others, industry officials say. Without it, they say, money to help start the next Uber or Airbnb would dry up. “It’s their potential for carried-interest capital gains that is the sole economic incentive for launching a fund and sourcing investments into innovative start-ups,” said Ben Veghte, spokesman for National Venture Capital Association.
“It is a reward on the risk that is taken,” said Jason P. Andris of Venture Investment Associates. “There should be an incentive for investing risk capital in start-ups and creating value and jobs, which is a public good.”
Others argue the break creates the wrong incentives.
“It is deeply unfair for the very wealthiest to be taxed at a lower rate than a doctor or a firefighter or a policeman,” said Victor Fleischer, a law professor at the University of San Diego, who has studied the issue. “There is no shortage of people who want to become private equity managers. There is no reason that we would want to use the tax code to subsidize people to get into this industry.”
Much of the criticism of carried interest has been focused on its use by hedge funds. “The hedge fund guys didn’t build this country. These are guys that shift paper around and they get lucky,” Trump said in a 2015 interview with CBS’s “Face the Nation.” “They are energetic. They are very smart. But a lot of them — they are paper-pushers. They make a fortune. They pay no tax. It’s ridiculous, okay?”
Ways and Means Committee Chairman Kevin Brady (R-Tex.) offered an amendment to the tax bill currently being debated in the House this week aimed at the industry: Assets must be held for three years instead of one before a taxpayer could claim the special carried-interest tax treatment. Brady said in a Monday CNBC interview that the amendment would “make sure it really is focused on those long-term, traditional real estate partnerships” rather than on hedge funds.
Brady’s provision is “ineffective,” said Rosenthal of the Tax Policy Center. Hedge fund managers don’t often make long-term bets, he said. While a private equity firm may spend years turning around a company before cashing in the profits, hedge funds typically make short-term bets that may last hours, days, weeks or months. It is often not long enough to take advantage of the lower tax rate on long-term capital gains, said Rosenthal.
The Republican approach could affect one group of investors: activist hedge fund investors. These investors, such as former Trump adviser Carl Icahn, sometimes hold onto investments for eight months to two years as they try to persuade a company’s management to change their strategies and increase profits. “They are the ones that could potentially be hit,” said Fleischer.