Is Trump Serious About Trying to Close the Private Equity Carried Interest Loophole?

The Financial Times, in a new story, tells us that Trump is reviving a tax reform element he pursued unsuccessfully in 2017, that of closing the so-called carried interest loophole. It enables private equity kingpins to convert what ought to be treated as labor income (receiving profit participations from managing other people’s money) into capital gains, which is taxed at a much lower rate.

The short version of what follows is that we expect this to be at most Mexico-Canada tariffs 2.0: that even if Trump presses forward in a serious manner, he’ll declare victory after getting minor concessions, or here, tax code changes. This seems like a particularly likely outcome given the change in Trump’s position compared to his first term. Then, Hillary was the candidate of financiers, while the wealthy end of Trump’s backers consisted in large degree of local notables, meaning those who were influential on a city or state level, but not nationally, and often identified as self-made.

Trump now has considerable support from Silicon Valley squillionaries, which includes indirectly and even directly, venture capitalists who are convinced they need the carried interest loophole to keep their current level of high living. Trump now also has the support of Zionist money men like Bill Ackman. Admittedly, hedge funds don’t benefit much from the carried interest scam unless they are taking private equity like positions (which some do, recall Chatham Asset Management, nominally a hedge fund, having been an infamous owner of American Media Inc., of National Enquirer infamy).

We have written many times about the carried interest abuse, including past efforts to end or curtail it that looked like they were about to get done but of course did not (a gander through our archives shows, among others, serious assaults in 2015 and 2019 that came to naught. Note the Trump attempt wasn’t seen at the time as having enough potential to get done to merit much media coverage). An overview of the practice from a 2015 post:

The reason the “carried interest” label is a misnomer relates directly as to why it is also a tax abuse. Money managers like private equity and hedge funds enter into fee arrangements that include what the IRS calls a “profits interest” and a layperson would describe as a profit share. These firms enter into a prototypical “2 and 20” fee structure, meaning a management fee of 2% per annum of the committed capital plus 20% of the profits, usually after a hurdle rate is met.

Due to clever tax structuring, that 20% is taxed at a capital gains rate even though the managers have no or only a token amount of capital at risk (as in the investors generally require that the fund manager invest some of his capital alongside that of the investors, but it is typically in the 1% to 3% range, and in many cases, that amount isn’t actual cash, but instead a deferral of some of that 2% management fee, which by definition is excessive if the manager is in a position to defer it.*). In other words, they are being taxed at a preferential capital gains rate on what by any commonsense standard is ordinary income and should be taxed at ordinary income rates.

Key sections of the Financial Times article, Donald Trump seeks to close tax loophole enjoyed by private equity groups:

Donald Trump has told lawmakers he wants to end the special tax treatment of private equity and hedge fund profits known as “carried interest”, setting up a potential clash with America’s wealthiest financiers….

Many Republicans and some Democrats have resisted efforts to clamp down on that preferential treatment, helping the private equity industry maintain the status quo. A previous attempt early in Joe Biden’s presidency failed.

But Trump, who had tried and failed to eliminate the special tax treatment of private equity profits in 2017, has now put it back on the table.

“The battle over carried interest is likely going to be the toughest yet,” said one strategist who works closely with the private equity industry. “Trump wanted it gone in 2017 and was stymied by Congress, but today’s congressional Republicans hardly resemble darlings of high finance and are far more willing to fall in line behind the president.”

I could be proven wrong, but I think this view is naive. Private equity firms are staggeringly rich and powerful. For more than two decades, the industry has been the biggest source of fees to investment banks, white shoe law firms, and the top consulting firms. They are entirely capable of copying from the AIPAC playbook and threatening non-complaint Congresscritters of being primaried on their re-election bids.

Some additional detail:

The 2017 tax bill narrowed the scope of the benefit for private equity by extending the number of years an investment has to be held before the preferential treatment kicks in from one to three years. One scenario would be a further extension of that timeframe, as an alternative to a complete elimination of the loophole.

Remember that the pervasive use of the misleading “net present value” measure, which makes profits early in the life of an investment look more attractive than they are, encourages private equity firms to take some profits quickly to goose apparent returns. So the tax punishment for a less than three year holding period would seem to conflict with that practice.

I have not consulted any tax experts on this beat, but it seems that this implementation would encourage the use of the notorious “dividend recap” strategy. There, rather than sell the company quickly, the private equity owners drain value out of them by adding more debt and then paying investors a special dividend. One of the common methods for implementing this strategy is to sell company owned real estate (think retail stores or hospital buildings) to a new entity, and then have the company lease the properties, usually at inflated rates. This means the newly created real estate company can also be sold because it has a (theoretically) solid income stream. This is merely a crude idea based on recent practices; private equity tax lawyers get very big bucks for their schemes.

Similarly, the private equity partners could simply borrow funds so that instead of having a fake carried interest (as in at-risk capital contribution instead of a profits interest). Financial Times readers concurred that it would not be all that hard to work around a tax change were it to come about. For instance:

Sensiblequestions
The basic problem with trying to treat “carried interest” as income is that it’s actually not that hard to restructure things so that the same economic return is more clearly earned as a capital gain.

So it would be a short-term victory. No one is going to sit around and just pay more tax on the same economic return.

Its a bit like the “main home” exemption from capital gains tax in the UK – its intended only to allow tax free returns on houses you really live in, but many builders/renovators use it to turn around, tax free, a house they invest in to do up by pretending they live there for a bit. Very hard to crack down on.

Same with “carried interest” which is just an industry term for the means by which investors in a fund agree that the manager of the fund will take a skim of the fund profits as an incentive to ensure that the fund does well.

So we’ll keep our eyes on this proposal but I would not get my hopes up.