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How Private equity Won Its Battle Over Carried Interest.- Newshubweek

How Private equity Won Its Battle Over Carried Interest.
Written by Arindam

The carried-interest loophole will live to fight another day, a sign that Wall Street’s lobbying prowess remains largely intact in Washington.

Sen. Kyrsten Sinema (D-Ariz), the last Democratic holdout in the Senate to passing the “Inflation Reduction Act,” agreed to vote for the bill if it removed a measure to reform carried interest.

Her support appears to have sealed the bill’s passage in the Senate, where all 50 Democrats must back it since every Republican is expected to vote no. The Senate Parliamentarian must still sign off.

The bill is expected to be introduced on Saturday. Assuming it passes, the legislation will go to the House and then to President Joe Biden. 

Carried interest is a tax break largely used by private equity fund managers and firms. In essence, it taxes gains on the sale of assets at the long-term capital gains rate, which tops out at 23.8% at the federal level. General partners of private equity funds receive much of their compensation as carried interest.

It’s considered a loophole in the tax code since, in effect, it taxes high levels of compensation much lower than rates paid by wage earners–which top out at 37% at the federal level. Advocates of tax fairness say it allows a private equity executive earning $1 million a year to pay a lower rate than, say, someone earning $200,000.

The Tax Cuts and Jobs Act of 2017 placed some restrictions on carried interest, extending the required holding period for some types of assets from one to three years.  

The Inflation Reduction Act would have gone further, extending the holding period to five years, among other reform measures.

Yet carried interest has proven itself to be the Freddy Krueger of tax loopholes–nothing can kill it. Efforts to reform carried interest have been kicking around Washington for decades. Every time a bill has been introduced to kill it, it has died on the Congressional vine, despite every Democratic and Republican president voicing opposition to the tax break.

What makes it so resilient?

For one thing, Wall Street’s lobbying machine. Sinema, for instance, received more than $2.2 million in campaign donations from Wall Street firms and other investment companies from 2017 to 2022, according to Opensecrets.org, a group that tracks money in politics.

Sinema received donations from some of the biggest, public alternative asset managers, including

Blackstone

Group (ticker: BX),

Apollo Global Management

(APO),

Carlyle Group

(CG),

KKR & Co
.
(KKR), Welsh Carson, and Andreessen Horowitz, according to Open Secrets. The website notes that the organizations themselves didn’t donate. The money came from industry PACs or individuals associated with the industry.

Those donations hardly make Sinema unique.

Senate Majority Leader Chuck Schumer (D-N.Y.) was actually the top recipient of money from private equity and investment firms in the 2022 election cycle, receiving $1.2 million, according to Open Secrets. Schumer received donations from firms like KKR and Blackstone. Sinema ranked seventh in the 2022 cycle, receiving $286,700.

Indeed, Wall Street donated to Senators who want to close the carried-interest loophole. Among them: West Virginia Sen. Joe Manchin (D-W.VA), who took in $343,751 from private equity and investment firms in the 2022 cycle, ranking third among recipients, according to Open Secrets.

Some veteran tax attorneys say it’s unclear why Sinema rode to the carried interest rescue this time around.

“Why does Sinema have such a bee in her bonnet on changing carried interest taxation? You might’ve expected someone from Silicon valley or New York to oppose a rule change. That is a head scratcher,” said Daren Shaver, a tax partner with law firm Hanson Bridgett.

One answer, of course, is simply the politics of it all. Machin has positioned himself as an economic populist in a largely red state. He also opposes another tax break favored by blue-state Democrats–the so-called SALT deduction, which was sharply curtailed by the 2017 tax reform law.

Schumer needed Machin’s vote to secure support for a critical piece of legislation for Democrats–impacting climate, energy policy, and prescription drugs in a $739 billion package. Curbing the carried interest tax break was a relatively minor concession, expected to raise $14 billion.

Sinema, for her part, managed to unseat a Republican to win office in a swing state. Her political future may hinge on threading a fine needle when it comes to taxes. Arizona isn’t known as a state friendly to any politician who votes to raise taxes on businesses or individuals.

Granted, the bill has plenty of other corporate tax increases that Sinema appears ready to accept. They include a 1% tax on stock buybacks that was added to make up for the loss of carried-interest revenue and another tax break that Sinema wanted preserved.

The industry, for its part, represented by the American Investment Council (AIC), argues that the tax break is crucial for maintaining employment and investment in a wide swath of companies.

“The private equity industry directly employs over 11 million Americans, fuels thousands of small businesses, and delivers the strongest returns for pensions,” AIC President and CEO Drew Maloney said in a statement to Barron’s. “We encourage Congress to continue to support private capital investment in every state across our country.”

Some analysts say the economic arguments do have merit. Robert Willens, a professor of taxation at Columbia Business School, points out that private equity often provides funding to businesses as an investor of last resort.

“Private equity firms keep our capital markets running efficiently by supplying so much investment capital for worthy projects that might never be launched if private equity did not serve as sort of an investor of last resort,” he says. “It may be wise to not take steps to discourage the firms from doing what they’ve been doing so well for so long.” 

The tax problems could be solved, he says, if the IRS could somehow tax private equity managers on their receipt of a profit interest in a business, which could be taxed liked wages. Yet case law is muddled on whether that is even possible, Willens says.

“The problem is that the receipt of a profits interest is not currently taxed,” he says. “If it were, it would be taxed as compensation income. There is no theory that would allow such receipt to be taxed as a capital gain.” 

None of this means the fight is over. Sinema, for one, has said she will work with Sen. Mark Warner (D-Va.) to enact carried interest tax reform.

Write to Luisa Beltran at luisa.beltran@dowjones.com

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Arindam

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