Usually the “20” of the Two and Twenty compensation system for alternative asset managers, it’s investment returns above a certain hurdle rate that goes to the general partners (GPs) of these funds. Instead of being taxed as ordinary income, which for most GPs would be the top marginal rate of 37 percent, it’s taxed at the top capital gains rate of 20 percent. The term “carried interest” dates back centuries ago when medieval merchant would carry goods on their vessels. To compensate for the risk of the journey, the merchants would receive 20 percent of the profits on the carried profits.
The tax treatment of carried interest as a capital gain has been US law for over half a century. The Tax Cuts and Jobs Act of 2017 extended the holding period of a GP’s carried interest from one to three years in order for the returns to qualify as long-term capital gains.
It’s hard to argue with a straight face that the private equity and venture capital firms today are bearing the same risks of the merchants from centuries ago, and thus deserve to have carried interest treated differently from ordinary income. A member of Congress is not going to lose re-election because they voted to end the preferential tax treatment of carried interest.
But understanding carried interest is to understand the workings of DC. It’s an issue a lot of people care a little about but a few people (with a lot of money and lobbying clout) care a lot about.
So is now the time carried interest finally meets its fate?
Senators Tammy Baldwin (D-WI), Joe Manchin (D-WV), and Sherrod Brown (D-OR) introduced the Carried Interest Fairness Act of 2021 yesterday. A companion bill to a House version introduced in February, it would eliminate the preferential tax treatment of carried interest, changing it from being treated as capital gains taxed at 20 percent to ordinary income taxed up to 37 percent.
Besides the three co-leads in the Senate version, there are 11 other Democratic co-sponsors. Having 14 Democrats, including the most conservative Democrat in Manchin, put their names on the bill on paper would add momentum to the push for eliminating carried interest. But so far, it’s just the usual suspects coming out in support of a change.
The Carried Interest Fairness Act has been introduced in each Congress going back years. While Manchin did not co-sponsor the 2019 version, he did co-sponsor the 2017 and 2015 versions. The only new name on the list of sponsors for the bill is Brown, who has signed on to previous measures to end carried interest in the past. Notably, of the 14 Senate Democrats, just three are on the Senate Finance Committee, which has jurisdiction over the issue and receives the brunt of the lobbying from carried interest advocates.
Senate Finance Committee Chair Ron Wyden (D-OR) yesterday announced his committee will begin consideration of “jobs and infrastructure” legislation this month. He did not explicitly say this will include tax provisions, but it’s certainly possible. While Wyden isn’t a co-sponsor of the Carried Interest Fairness Act, he released his own bill last Congress called the Ending the Carried Interest Loophole Act.
But the real test in a 14–14 Senate Finance Committee on carried interest won’t be what Wyden does, but what some of the other senior members, who in the past have shown a willingness to listen to private equity and venture capital interests, do. This includes Senators Debbie Stabenow (D-MI), Robert Menendez (D-NJ), and Maria Cantwell (D-WA). It’s one thing for Democrats to support the idea or a bill ending the preferential tax treatment of carried interest when they are in the minority or there is little chance of it passing. However, the pressure and calculations are different when there’s an actual chance of passing legislation. That dynamic is playing out more publicly on the issue of drug pricing.
The same dynamic goes in the House Ways and Means Committee. Once a cosponsor of legislation to eliminate carried interest’s tax treatment in 2007, House Ways and Means Committee Chair Richard Neal (D-MA) has become a powerful ally of the private equity industry. Back in 2017 when Republicans were debating whether to eliminate carried interest in the TCJA, Neal joined a group of bipartisan lawmakers, including Rep. Kevin Brady (R-TX), the Republican leader of the Ways and Means Committee, in a letter supporting the preservation of carried interest’s tax treatment. The private equity industry is a big donor for Neal and he has reciprocated the support in not just supporting carried interest but by going to bat for them in the surprise medical billing debate over the last two years.
There will be a Ways and Means Committee hearing next week titled “Leveraging the Tax Code for Infrastructure Investment.” The keyword here is “leverage.” Neal is a major proponent of leveraging bond financing to invest in infrastructure. He’s pushing back against certain tax increases by advocating for partial bond and deficit financing for the American Jobs Plan (AJP) and American Families Plan (AFP). A greater willingness for bond and deficit financing means less need for tax increases.
To be sure, taxing carried interest as ordinary income would only raise $14 billion over ten years, according to the Congressional Budget Office (CBO). So its value isn’t as a pay-for but rather as a political messaging tool.
If Democratic leadership decides ending carried interest is a top priority, they could try to roll the powerful Neal and other Democratic defenders. But it’s not at all clear leadership sees this as a top priority. House Speaker Nancy Pelosi (D-CA) criticized Republicans back in 2017 for not ending carried interest, but she also has close ties to the venture capital community, another beneficiary of carried interest. When Democratic leadership can only afford to lose three Democratic votes in the House and zero in the Senate, there’s a push and pull over what is included in legislation that can get the votes. When it comes to the AJP and AFP, changing the tax system is secondary to the spending ambitions. If Democratic carried interest supporters decide to put political capital in defending the provision, it’s hard to see leadership seriously pushing back.
Still, now is probably the most opportune moment for the elimination of carried interest in over a decade, as well as an increase in the capital gains rate for those making more than $1 million. If carried interest is to end, it will likely end not with a bang but with a whimper. If Neal decides to support ending it, he may keep his cards close to his vest and not advertise the legislative push until absolutely necessary to minimize time for lobbyists to mobilize against the measure.