Changing the Taxation on Carried Interest Stands to Impact Business and Investment

Policymakers are currently on the path towards extending key provisions in the Tax Cuts and Jobs Act (TCJA). While this remains a top priority, many lawmakers are discussing other tax reform opportunities to include in the legislative package. One such proposal that has gained some traction is the idea to close the carried interest “loophole.” Carried interest is the share of private equity profits that the fund’s managers take as compensation. The interest is taxed as a long-term capital gain rather than as regular income. While critics insist that this “loophole” is an unfair tax benefit, it allows investment managers to make crucial business investments.

The TCJA did important work to promote business investment through the protection of carried interest. By extending the qualifying period from one to three years, long-term investment was strengthened. As the Taxpayers Protection Alliance has argued, the “loophole” is a worthwhile provision of tax law. It is not an issue of fairness, as money invested from carried interest is dependent on the market. The profits for a fund could be drastically different from year to year, so taxing them like capital gains makes sense. Introducing a tax increase on carried interest would adversely impact investment in both small and large businesses, which could hurt growth and innovation.

Advocates of repealing the “loophole” argue that the taxation of carried interest creates distortion in the tax code. However, the increase in the qualifying period from the TCJA already has shifted how investment managers adhere to regulations about qualifying earnings. Changing the tax status of carried interest will cause significant changes to business investment, harming job growth. Shifting the taxation status will also adversely impact rates of return for institutional investors, which will then put broader pressures on a variety of funds.

Some proposals even include a retroactive application of ordinary income taxation. This would be disastrous. It would significantly hurt American firms and their ability to create new partnerships and investments. Additionally, some lawmakers argue that closing the “loophole” is a chance to generate revenue. However, a more sustainable path for Congress to reduce the deficit should be the continued simplification of the tax code combined with a massive reduction in spending.

A proper taxation regime for carried interest is an essential incentive for investors to create partnerships and invest in new technology. Private equity supports millions of jobs and enhances economic competitiveness. Even beyond private equity, eliminating the carried interest “loophole” will harm American startups who rely on private equity for seed funding to thrive and grow.  

If the taxation status of carried interest is changed, investment firms will necessarily have to change their management fees and structures. This would then have downstream consequences for clients and prospective customers. All these proposed changes show that closing the fictitious carried interest “loophole” would do significant damage to investment and have broader impacts on economic growth. Congress should focus on extending TCJA – and seek to do so on a permanent basis – and avoid changes to the tax code that will negatively affect business investment.