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Carried Interest Helps American Businesses Grow and Succeed

Whether it’s a local pizza shop or a large scale manufacturing company, businesses need a combination of knowhow and money to grow and succeed. The Tax Code has historically treated the people who invest their knowhow and the people who invest their money equally.

A carried interest is a type of ownership interest in a partnership (or business) and is fundamentally a discussion of partnership tax law and Capital Gains tax rates. The carried interest is also referred to as a profits interest, because the holder of the interest is entitled to a portion of the profits from the company. Carried interest is also synonymous with “sweat equity:” people who have a carried interest are usually those who invest their time, energy and knowhow into a business.

The other main type of ownership interest in a business or partnership is a capital interest. People who have capital interests are ones who have invested money—or another form of capital like property—in a business or partnership.

When a partnership distributes profits to its owners, the Tax Code has historically treated the owners the same way, regardless of whether they have carried or capital interests. This includes when there is a long-term capital gain from the sale of the business: both carried and capital interest holders are entitled to the long-term capital gains tax rates. As such, both people who invest their time and people who invest their knowhow are rewarded for the risks they take.

When people refer to “eliminating carried interest,” the rhetorical device became synonymous with raising taxes on hedge fund managers. However, recent 2017 tax changes have largely excluded hedge fund from participating in carried, and even negatively impacted a high-level amount of other investments. Real estate, private equity, venture capital and other similar partnerships still use it. The carried interest holders in these partnerships take similar risks and use their sweat equity. They often separately pay higher ordinary income taxes on any services. (e.g. a private equity or real estate fund charges a fee of 2% for the management of the assets).

A Change would Harm Long-term Investment

While there would be dramatic decrease in investment overall, the incentive would also change long-term investment dynamics with new perverse incentives in the Tax Code. Many investors would become increasingly short-term oriented. Rather than hold an investment for 3 years to get carried interest capital gains treatment as currently required by the Tax Code, making carried interest rates equal to ordinary rates would decrease the incentive to hold an investment for the long-term to receive a tax preferential treatment.

Not Enough Money to Build a Road from Austin to Dallas

The Congressional Budget Office estimates changing the tax treatment of carried interest would raise $14 billion – over 10 years. That amounts to just $1.4 billion a year. To put that figure in perspective, $1.4 billion would pay for:

That $1.4 billion represents 0.046 percent of a $3 trillion infrastructure package, meaning you would need 2,142 comparable pay-fors to fund this legislation.

Congress Just Changed the Tax Treatment of Carried Interest

Congress addressed carried interest in the 2017 Tax Cuts and Jobs Act to protect long-term investment. That change required investors to invest in capital assets for more than three years before receiving long-term capital gains. As workers and local economies recover from the COVID-19 pandemic, this would be the worst possible time for Washington to reverse this responsible policy and punish long-term investment that creates jobs and builds businesses in communities across America.

Click here to watch a brief video explaining how carried interest helps American businesses grow and succeed.

About Private Equity

Private equity is an important driver of economic growth in the U.S. Firms invest hundreds of billions of dollars into the U.S. economy each year. Private equity firms work to improve operations, governance, and competitiveness by hiring managerial talent, advancing technology, and expanding distribution channels. The private equity industry supports more than 8 million American jobs and strengthens retirements across the country. The majority of private equity backed companies are under $100 million in revenue and 500 employees.