Biden’s Plan Would Eliminate Private Equity’s Coveted Tax Break

Private equity’s most lucrative tax break is in peril once more.

Included in President Joe Biden’s plan to fund an ambitious expansion in social spending, released Wednesday, is a call on Congress to abolish the preferential treatment given to a key method of compensation for private equity managers.

In addition to salaries, those managers rely especially on a share of the appreciation in the assets they oversee -- known as carried interest. Those profits -- sometimes in the millions of dollars -- have been taxed as capital gains, at a rate much lower than the top marginal income tax rate applied to wages.

Lawmakers have long battled over the benefit’s validity, and Congress will ultimately be the arbiter of the latest proposal. Biden’s plan would not only raise the top rate on capital gains for the wealthiest, but do away with the tax break altogether.

“Permanently eliminating carried interest is an important structural change that is necessary to ensure that we have a tax code that treats all workers fairly,” the White House said in a fact sheet on the plan. The aim is to ensure fund managers “pay ordinary income rates on their income just like every other worker,” the document said.

Looming Fight

Biden’s proposal is one component of a $1.8 trillion, 10-year spending program that would be funded in part with tax increases on individuals.

The private equity industry has successfully fought for years to keep the tax break, and it’s unclear what the final legislation will look like as negotiations proceed in Congress.

Managers are compensated in two main ways: Annual management fees from investors are taxed as ordinary income, but on top of that, managers typically take a 20% cut of the profit on deals when realized, which -- because investments are held for a longer period of time -- is taxed at the lower capital gains rate.

The current capital-gains rate is 20%, while the top marginal income tax rate is 37%. Biden aims to boost the top income rate to 39.6%, with that same level applied to capital gains for households earning over $1 million.

Playing Defense

The most recent attempt to address what critics call the loophole of carried interest was under President Donald Trump. In 2017, the Republican tax reform fell short of doing away with the benefit altogether, leaving it in tact for investments that are held for at least three years -- a big win for the industry.

Critics have argued that carried interest is just like any other fee and should be treated that way. Proponents say it encourages long-term investment.

“Private capital is supporting millions of jobs, strengthening pensions, and delivering innovation that will help end the COVID-19 pandemic,” said a spokesperson for American Investment Council, private equity’s lobbying group, before details of the Biden plan were released. “The administration and elected leaders need to ensure policies continue to support and encourage private capital.”

The private equity industry has also argued that doing away with carried interest would do little to help raise tax revenue. In 2018, the Congressional Budget Office estimated that taxing carried interest as ordinary income would raise $14 billion over nearly a decade.

Who’s Hurt

The impact of any changes would likely affect senior professionals at private equity firms the most, since they tend to get a bigger slice of the carry. That could prompt changes to how private equity managers are compensated -- such as eliminating so-called fee waivers, which have been used by deal-makers to capture tax benefits by converting management fees to carry.

It could also have an impact on talent by helping level the playing field with other parts of Wall Street, such as investment banking, that don’t dangle carry as an incentive. Funds that focus on lower-returning asset classes such as infrastructure and those that have weaker returns could also face challenges keeping their top performers.

Still, some experts believe there is unlikely to be a mass exodus from the industry if the Biden team is successful in making any changes to capital gains or carried interest.

“As long as private equity returns are among the highest across asset classes overall, private equity managers are unlikely to depart for greener pastures,” said Kelly DePonte, a managing director at Probitas Partners, which helps raise money for private equity funds.

As always, a massive lobbying push from the industry is expected. But this time, experts agree that while the proposal is likely to change, private equity is unlikely to emerge unscathed.

“Both sides of Congress and the administration are looking at carried interest as low-hanging fruit in terms of where they can generate revenue,” said Jeremy Swan, managing principal for financial sponsors and the financial services industry at accounting firm CohnReznick. “I don’t think there’s sufficient resistance to that to prevent any changes.”

©2021 Bloomberg L.P.

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