Carried interest update

Ways and Means proposal is a mess

And we’re off to the races with legislative text from Ways and Means, to be marked up tomorrow and Wednesday. Lots to think about, but I thought I’d start with a quick update on carried interest.

Status quo: § 1061

TCJA enacted § 1061, which changes the holding period for long-term capital gains from one years to three years for applicable partnership interests (i.e. carried interests or profits interests in real estate, private equity, venture capital, etc.). Section 1061 might have been the most cynical item in the TCJA, as it was designed to look like it did something to close the carried interest loophole without actually increasing anyone’s taxes. Hedge funds that actively trade securities typically get short-term gains anyways, so they weren’t really affected. Private equity and venture capital usually hold investment for 4-6 years, maybe longer, so they weren’t really affected, and it appears that Section 1061 was drafted by industry with this in mind. Some activist hedge funds got caught in the net, and maybe some real estate deals. But § 1061 also left in place some workarounds so those who wanted to exit before three years could do so.

Senator Baldwin: Tax Carried Interest as Ordinary Income

Before looking at the Ways and Means proposal, it’s worth a moment describing what’s on the table.

Senator Baldwin’s legislation has been the leading reform vehicle in the Senate for some time; its bones can be traced all the way back to Representative Levin’s 2007 bill. It would treat carried interest allocations as ordinary income, which accords with most people’s intuition about the right tax result.

The legislation is complex, but the details have been ironed out, and most of the complexity has to do with defining an investment services partnership interest (ISPI) subject to the tax, and this complexity is no different than determining an applicable partnership interest under current § 1061.

JCT has estimated the bill would raise about $16B over ten years. It’s an absurdly low estimate (more on this in a minute).

Senator Wyden: Deemed Loan approach

Senator Wyden’s carried interest proposal approaches the problem from a different angle, which I first described as a “cost of capital” approach in my Two and Twenty paper. The idea is that carried interest is economically similar to zero-interest loan from the other partners in the fund (i.e. that they are “carrying” the GP’s interest. A profits interest of 20% in a $100 million fund is the same as borrowing $20 million on a nonrecourse basis from the LPs and using the $20 million loan proceeds to buy 20% of the fund. If the fund appreciates in value, the GP can pay back the loan and enjoy 20% of the profits of the fund. If the fund depreciates in value, the GP can walk away from the (nonrecourse) loan. In the meantime, the GP pays no interest, but recognizes no income under § 7872 for below market rate loans because there is no actual loan.

Senator Wyden’s proposal would instead treat the carried interest as a deemed loan, with the forgone interest component treated as deemed compensation. Importantly, the legislation treats the loan as high-risk, setting the applicable rate at the 5 year corporate bond rate (currently about 1%) + 9% — i.e., about 10% per year. In the example above, the GP would recognize about $2 million in compensation income each year. When profits are allocated from the fund, they would receive capital gains treatment so long as the 1 year holding period is met.

JCT estimates the bill would raise $63 billion over ten years — about 4 times as much as the Baldwin bill. For this reason (and because Senator Wyden is the chair) it’s worth paying more attention to this proposal.

Ways and Means: Extend holding period from 3 to 5 years.

Ways and Means would keep § 1061 and extend the holding period from 3 to 5 years. It also directs the Treasury Department to promulgate regulations addressing some of the abusive workarounds (like carry waivers) that practitioners have developed.

The bill would raise $14 billion over 10 years. (Yes, it’s hard for me to understand why this would raise $14 billion but treating all gains as ordinary income would raise about the same amount. It seems JCT may have finally updated its models, in which case we really need an updated score for the Baldwin bill.)

The Ways and Means proposal is deeply flawed, in my view, by moving the holding period out only to 5 years. GPs with investments that are ready to exit in years 2, 3, and 4 will be tempted to hold on to those investments until they hit the 5 year mark. This is a problem for 2 year investment under current law--but it will be much, much worse as significant numbers of private equity and venture capital investments ripen in the 4-6 year window. GPs have a fiduciary duty to consider the best interests of the limited partners rather than their own personal taxes when timing an exit. But it would be naive to think that GPs won’t consider the timing and/or look into workarounds (e.g. borrowing against the carried interest, using the carried interest as collateral for the loan) to avoid the realization of gains. The bill also carves out real estate from the 5 year holding period. '

It’s hard to see the Ways and Means proposal as anything other than the Democratic version of § 1061 — designed to give the appears of doing something on carried interest reform without actually doing so. There is much to admire in the Ways and Means proposed legislation, but this carried interest piece is disappointing. I am hopeful that Senate Democrats will take a stronger stand and win the day as things move forward.

— Vic