For over a decade, regulators on both sides of the aisle have tried to clamp down on a specific tax strategy known as the “carried interest provision.” Last week, the latest attempt to eradicate this provision was defeated yet again.
A modification to the tax treatment of carried interest was proposed in the original draft of the Biden administration’s Inflation Reduction Act. However, objections from Senator Kyrsten Sinema (D-Ariz.) kept the amendment out of the final bill before it passed.
The loophole has survived tighter regulations countless times before. In fact, it dates back to the 16th century, when Europe gave preferential tax treatment to sailors willing to make risky voyages to Asia and America. The captains of these ships were allowed to keep 20 percent of the profits of these ventures, which was taxed as a return on investment rather than ordinary income.
This is how the carried interest loophole was created, according to Sir Ronald Cohen’s book The Second Bounce of the Ball: Turning Risk into Opportunity. Today, the strategy underpins the entire investment industry. In fact, carried interest accounts for roughly 84 percent of the total compensation of investment managers, according to a survey by Heidrick & Struggles in 2021.
The debate over this tax maneuver remains as controversial as ever. Critics argue that the loophole offers preferential treatment to the wealthiest segment of society. Hedge fund managers, venture capitalists, and private equity investors can lower their tax bills substantially and defer taxes for several years under the current structure of this provision.
However, some argue that the provision incentivizes precisely what the economy needs – growth. “While the headlines around this topic are often focused on the large global assets managers who focus on large companies, one of the U.S.’s most valuable assets is its entrepreneurial culture of building innovative businesses leading to job creation,” says Brett Hickey, CEO of Star Mountain Capital.
“This job creation dynamic occurs more frequently in the small- and medium-sized business space than the larger company space,” Hickey says. “Smaller asset managers are the ones who focus on these smaller companies so we hope government policy continues to support increasing access to growth capital to these companies that are growth engines of the economy and job creation.”
Regardless of its current status, it seems likely that the provision will come under scrutiny again in the future. Hedge funds and private equity firms may have dodged a bullet this time, but, just like the Asian-bound European ship captains of the 16th century, they are likely to face choppy waters again.