For many years, private equity firms have enjoyed favorable treatment under U.S. tax laws, but it looks like those days are numbered.
Carried interest income from private equity investments is currently taxed at 23.8 percent—the long-term capital gains tax plus an Obamacare surcharge. The reasoning behind taxing carried interest as a capital gain is that fund managers should receive tax relief since they’re entrepreneurs who took risks rather than people who earned the money through ordinary employment.
A proposal by the Trump administration would cause private equity income to be taxed as ordinary income, which could bring a tax rate as high as 39.6 percent. It would also remove the deductibility of interest expenses.
Currently, private equity firms can finance buyouts by causing the company to go into heavy debt, and then they can deduct the portfolio company’s cost of debt from their taxable income. This is used to reduce the target company’s tax burden.
Critics of the proposed changes argue that the current tax structure encourages entrepreneurship by allowing the kind of risk-taking that allows companies to grow. The American Investment Group, a lobbying organization for PE and venture capital investors, has spent millions to convince lawmakers to maintain the current structure.
“Any new tax policy targeting interest deductibility would harm the economy by raising costs on businesses of all sizes and types, which would reduce investment and growth,” James Maloney of the American Investment Council told Bloomberg.
On the other hand, some in the PE field argue that the carried interest loophole should be removed.
“Expertise and talent [in managing a fund], no matter how great, is a service,” said John Hooker, who represents the Patriotic Millionaires, a group of 200 wealthy Americans lobbying to end the carried interest loophole. “Every other American in this country is taxed for their services, or labor, as ordinary income. That’s what carried interest is, or should be—ordinary income.”
The removal of the carried interest income tax rate was one issue upon which both Hillary Clinton and Donald Trump agreed, so this change would have happened no matter who took office last year.
But with visits to the White House from top executives at private equity firms Carlyle Group, KKR, and Cerberus Management, it’s quite likely that the private equity sector will benefit in some way from the upcoming changes.
Although there has been a great deal of concern about this in the private equity sector, Trump’s talk of getting rid of the carried interest tax deduction also comes with a lowered corporate and individual tax rate.
Trump has said that he wants to tax all business income at 15 percent, but it’s not clear how that rate would apply to pass-through income, the type that private equity firms book. House Republicans are looking at a pass-through income tax rate of 25 percent, which is only a little bit higher than the current rate.
That lower corporate tax rate would do a lot to mitigate any harm caused by the removal of the carried interest and debt interest loopholes.
“If the tax laws were reformed in a manner consistent with Trump’s campaign rhetoric the PE sponsors [which are usually structured as pass-throughs] would likely convert to C-corps, and it would dramatically increase the number of potential shareholders,” said Chris Kotowski, a financial analyst with Oppenheimer.
“The net effect could be positive,” KKR manager Johannes Huth told Reuters.
It remains to be seen how tax laws will change under the current administration, but given the frequent communication between the White House and PE leaders, any changes are likely to be beneficial to businesses of all types.