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Election 2024

Carried Interest and the 2024 Election: What’s at Stake?

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Jane G. Ditelberg

Jane G. Ditelberg

Director of Tax Planning, The Northern Trust Institute

Fund managers who receive carried interests face unique income tax issues. Under current law, there is a three-year holding period requirement for long-term capital gains treatment; assets held less than that period are taxed at ordinary income rates. However, President Biden has proposed taxing all carried interests as ordinary income. The Republican and Democratic proposals on net investment income tax (NIIT) and on income tax rates would also impact the taxation of carried interests.

Private equity, venture capital and hedge funds (which we will refer to generically as investment funds), are often designed to compensate investment managers through a preferential interest in the fund’s profits, referred to as “carried interests.”

In the U.S., investment funds are often designed as limited partnerships, with the financial sponsor holding the general partnership (GP) interest and the other investors – which often include the sponsor or their principals – owning limited partnership (LP) interests. The GP interest is generally held via another entity such as a limited liability company (LLC) so that the sponsor can separately and privately allocate interests among individual principals or employees.

The partnership agreement typically provides that once the LP owners have received aggregate distributions equal to their original investment (return of capital) plus a fixed rate of return (the hurdle rate), the GP is entitled to 20% of all additional distributions and the LP holders as a group are entitled to 80%. This 20% is a carried interest. It operates as a performance incentive for the sponsor to maximize returns for the investors. The concept and the name are holdovers from sixteenth century shipping practices, where the ship captain often received 20% of the profit from the sale of the goods for taking the risk on the seas and the cost of transportation.

How are carried interests currently treated for income tax purposes?

Investment funds earn income in a variety of forms — from dividends and interest, rents and royalties, as well as short- and long-term capital gains generated by investments. As a partnership, these items of income retain their character as ordinary income or capital gains and are passed through to the partners. For most capital gains passed through from a partnership, the treatment as long- or short-term would also stay the same.

However, for carried interests, long-term capital gain treatment is only available if the asset sold has been held for three years, instead of the usual 12 months. This treatment applies both to sales of the interest in the fund as well as to sales of underlying assets owned by the fund. Short-term capital gains are taxed at the same rate as ordinary income, such as compensation, while long-term capital gains are taxed at more favorable rates. Both are additionally subjected to NIIT at 3.8%. This means that carried interest capital gains held for more than one but less than three years are taxed at rates of up to 17% more than other capital gains.

Unlike Canada, Germany and some other countries, the U.S. does not impose a tax at the time the partner is awarded a carried interest (for example, upon the formation of the investment partnership). The U.S. taxation is limited to the sale or disposition of the carried interest itself, and upon amounts received due to a carried interest. This means that in the U.S. there is no tax unless the taxpayer actually receives proceeds or distributions from the carried interest.

Changes on the Horizon

The income tax proposals of both major political parties in the U.S. include provisions that would impact the taxation of carried interests. President Biden’s policies announced ahead of the March 7, 2024, State of the Union address include a specific provision targeting carried interests. Former President Trump has not proposed any specific changes for carried interests, but his proposed changes to tax rates will impact the taxes paid on carried interests along with other income.

How would carried interests be taxed under President Biden’s proposals?

President Biden’s proposals include taxing all sales of carried interests and all distributions received from carried interests (not just those held for less than three years) as ordinary income. This is based on the view that carried interests are really compensation for services, rather than income from a capital asset. This idea has been percolating for some time and most recently surfaced in a bill introduced by Senator Ron Wyden last fall. Even if the provision to treat all proceeds from carried interests as ordinary income is not passed, another Democratic Party proposal is to tax all long-term capital gains as ordinary income for taxpayers with income over $1,000,000.

The Democratic Party’s tax proposals also include a top individual income tax bracket of 39.6% and an increase in the NIIT from 3.8% to 5%, both for single taxpayers with income over $400,000 and married taxpayers with income over $450,000. If all of these proposals were enacted, recipients of carried interests could be taxed at rates of up to 44.6% at the federal level.

How would carried interest be taxed under former President Trump’s proposals?

The Republican Party is advocating a reduction in the top capital gain tax rate from 20% to 15%. They have also proposed eliminating the NIIT, which would effectively reduce the current rate by 3.8%. Thus, the rate applicable to interests held less than three years (taxed at ordinary rates) would fall to 37% (from 40.8%) and the rate applicable to interests held three years or more would fall from 23.8% to 15%.

Comparing the Tax Treatment

We can compare the tax proposals with an example.

Penny is a fund manager and, upon creation of the fund in 2022, received carried interest. In 2024 she receives a distribution of $5,000,000. Under current law, this is taxed as ordinary income, and Penny will pay federal tax at 37% (the current highest marginal income tax rate) plus 3.8% in NIIT, for a total of 40.8% total federal tax, or $2,040,000. (State taxes, if any, would be in addition to that total.)

Suppose Penny receives another $5,000,000 in 2026.

Under current law, this distribution will be treated as capital gain. She will pay 20% capital gain tax plus 3.8% NIIT, for a total federal tax of 23.8%, or $1,190,000.

Under the Democratic Party’s tax proposals, Penny will pay tax at the highest ordinary income rate of 39.6% plus NIIT at 5% for a total federal tax of 44.6% or $2,239,000.

Under the Republican Party’s tax proposals, Penny will pay tax at a capital gain rate of 15%, or $750,000.

The chart below compares the federal tax Penny will owe (shown in blue) under the scenarios described in this section with her after-tax proceeds (shown in orange).

Comparing Taxes Under Current and Proposed Rules

Key Takeaways

It is too early to tell which candidates will be elected, or if agreement in the House, the Senate and the White House could even be reached on these tax proposals. However, owners of carried interests may want to consider the following:

  • Closely following the election results in not just the presidential race but also for representatives and senators. The balance in Congress will be a key driver of the final tax policy adopted.
  • Those who ultimately believe rates will go down can consider exploring if transactions can be postponed or paid out at a later date in order to reduce tax liability.
  • Those who believe rates are likely to rise can explore whether gains or distributions can be accelerated into the current calendar year, as long as they have been held for three years.
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Disclosures

© 2024 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.

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