Thinking about Carried Interest In Light of the Incoming Administration’s Tax Proposals

With the 2016 U.S. presidential election over, and tax reform at the top of the agenda, now seems like a good time to think about particular aspects of the incoming administration’s tax proposals.  One of ideas floated by the Trump administration is to tax carried interest.

What is Carried Interest?

Simply put, carried interest is income general partners of a private equity or venture capital fund might make for managing funds and is based upon profits earned by the funds.  Carried interest income is taxed at the lower capital gains tax rate, which has a maximum tax rate of 20% (plus the Obamacare 3.8% tax, if it applies).  The 23.8% cap is lower than the tax imposed on wage and salary income of 43.4% (the 43.4% is the sum of the top personal income tax rate of 39.6% plus the Obamacare investment tax of 3.8%).

Continuing in the vein of economic populism, Trump proposed taxing these money managers’ capital gains as ordinary income.

How Much Money is There That the Government Might Tax?

How much money is there that the federal government might get if it were to tax carried interest as ordinary income as opposed to capital gains?  The Congressional Research Service put the figure at about $17 billion over 10 years (it’s probably grown to around $20 billion over years now).  That’s a chunk of change for an industry that manages around $4 trillion in assets.

How Prevalent is Carried Interest?

With background and the amount of money at issue established, let’s address this question: how prevalent is carried interest?  Job Search Digest’s recently released 2017 Private Equity & Venture Capital Compensation Report provides some indication.  The report provides some fascinating looks at carry interest by job title, carried interest by years of experience, how the carried pool is shared, and the size of the carried pool.

The first look is what portion of the carry respondents in the survey reported.  Almost half of all respondents receive no carry at all.  This is unsurprising in one way because carry is only shared by those responsible for investment decisions and the percentage of carry is directly proportional to the years of experience and level of investment responsibility.  Still, it’s surprising to see that only around 12% of respondents receive than 10% of the carry pool.

The second interesting finding about carried interest is how long it takes – measured by years of experience – for private equity professionals to get in on the carried interest action, as shown in the following graphic.  Overall, the sweet spot seems to be between 5 and 10 years before a majority of professionals have carried interest.  Interesting.

Conclusion

Overall, the Trump administration proposed during the campaign season to tax carried interest as ordinary income.  Should Trump and Congress agree on such a proposal, it would mean a tax increase of perhaps $20 billion over the next 10 years and affect a large portion of the private equity and venture capital managers.  How private equity and venture capital professionals might respond is tough to gauge, but one thing is probably certain – they will respond in some way to keep as much money away from the federal government as possible.