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Tax Changes on Carried Interest- Necessity or Nemesis?

April 27th, 2010 No comments

No one wants to be "against" a jobs bill. (Photo: Sierra Club)

In the midst of unrest over budget deficits and November just around the corner, Democrats have been scouring for low hanging fruit. One proposal that keeps surfacing is the idea of changing the tax on carried interest.

For those of you who don’t know, carried interest is an incentive that is commonly used within the investment industry to encourage fund managers to maximize the funds performance. Essentially it is a chunk of the capital gains earned by the fund. Currently carried interest falls under the purview of the long term capital gains tax-roughly 15%. For years, however, Democrats have proposed taxing carried interest as ordinary income, thus raising the rate to as high as 33%.

It is important to note that to receive carried interest, a manager must return all capital contributed by the investors, and, in certain cases, meet a previously agreed upon rate of return (the hurdle rate). The point being, that if these funds don’t do well, the managers get nothing. It takes a trained eye to invest properly, and those individuals need to be compensated for wise investment decisions.

The investment industry is the key driver behind American business-big and small. Private equity funds raised capital totaling $240 billion in 2006 alone. Without these organizations, the capital needed to encourage growth simply wouldn’t exist. And in a time where we are struggling to pull ourselves out of an economic recession, raising tax rates on carried interest by 133% simply isn’t a smart move.

a visual explaination of carried interest

During the recent Jobs bill debate, the idea of taxing carried interest as ordinary income became a serious option of the table. $17.5 billion was a little too much to sweep under the carpet. Democrats knew they couldn’t go back to their districts and say “ we just added this on to your taxes.” At the same time, no one wants to tell their constituents that they voted against a “Jobs” bill. How could anyone be against jobs right?

When it was all said and done Congress decided to fund the Jobs Bill by giving the IRS tools to crack down on oversea tax havens, and by closing a loophole that investors had been using to avoid tax payments on dividends.

But the carried interest debate is far from over. With finance regulatory reform on the table, and congress looking to place shiny pieces of legislation before the president, easy cash grabs like carried interest are likely to come up again.

While finding funding for legislation is becoming more difficult, carried interest is something we should let be.