Carried Interest Is Back in the Headlines. What Would a New Tax Proposal Do? (Published 2022) (2024)

For years, Democrats and even some Republicans such as former President Donald J. Trump have called for closing the so-called carried interest loophole that allows wealthy hedge fund managers and private equity executives to pay lower tax rates than entry-level employees.

An agreement reached this week between Senator Chuck Schumer, the majority leader, and Senator Joe Manchin III, Democrat of West Virginia, would take a small step in the direction of narrowing that special tax treatment. However, it would not eliminate the loophole entirely and could still allow rich business executives to have smaller tax bills than their secretaries, a criticism lobbed by the investor Warren Buffett, who has long argued against the preferential tax treatment.

The fate of the provision was still not certain given the slim majority that Democrats hold in the Senate. They would need all 50 Democrats to back the legislation because Republicans have been unified in their opposition to any tax increases. But if the legislation did pass, the shrinking of the carried interest exception would bring Democrats a tiny bit closer to realizing their vision of making the tax code more progressive.

What is carried interest?

Carried interest is the percentage of an investment’s gains that a private equity partner or hedge fund manager takes as compensation. At most private equity firms and hedge funds, the share of profits paid to managers is about 20 percent.

Under existing law, that money is taxed at a capital gains rate of 20 percent for top earners. That’s about half the rate of the top individual income tax bracket, which is 37 percent.

The 2017 tax law passed by Republicans largely left the treatment of carried interest intact, following an intense business lobbying campaign, but did narrow the exemption by requiring private equity officials to hold their investments for at least three years before reaping preferential tax treatment on their carried interest income.