Illinois Bill Targets Carried Interest Loophole

A rare bit of good news comes via a bill making its way through the Illinois legislature. It seeks to close the carried interest loophole, which is near and dear to private equity and hedge fund kingpins, in that state. The carried interest loophole allows fund managers, who typically have only a 1% to 3% investment in the funds they operate, to treat the prototypical 20% profit share as capital gains income, which is taxed at a lower rate than labor income.

And before you say, “This will never happen,” consider:

Tax experts reported that there is widespread acceptance in the tax bar that the break is on its last legs, although if Trump gets his 15% tax rate for “small businesses” that would also happen to enrich super rich fund managers, it would make this effort moot ¹

Fund managers can achieve largely similar tax treatment by having a true carried interest, as in borrowing enough so that they’d have a 20% interest in the funds they manage. But that would also entail taking the risk of loss, something they don’t bear now

The Illinois bill does not become effective until similar legislation becomes law in Connecticut and New York…and both state have similar bills moving forward (one has to wonder why the supposed paper of record, the New York Times, has not deigned to take notice)

The legislation is among other things meant to embarrass Governor Bruce Rauner, who made his fortune in private equity. The bill will thus get votes from legislators who might otherwise be indifferent but want to put Rauner in a bad light

Notice that one of the sponsors is Daniel Biss, who we’ve written about previously for proposing another pioneering private-equity-related bill.

Key points from the Chicago Reporter (hat tip DO):

Social service agencies and public universities in Illinois are on the verge of collapse – while super-wealthy hedge fund and private equity managers (including Bruce Rauner and his top donors) evade millions of dollars in state taxes through an archaic loophole.

Legislation currently under consideration in Springfield would close that loophole and raise at least $473 million a year – perhaps much more – by effectively requiring the titans of high finance to pay income taxes the same way the rest of us do.

At this point it may actually be the most likely prospect for a legislature trying to do something about the state’s budget crisis….

Last year presidential candidate Donald Trump promised to eliminate the carried interest loophole (as did Bernie Sanders, Hillary Clinton and Jeb Bush), but with his administration heavily populated by Wall Street bosses, it now looks like another broken promise…

So reformers have taken the fight to the states. Legislation “repatriating” revenue lost to the federal loophole has been introduced in six states. It’s farthest along in the three states with the largest concentration of hedge funds and private equity firms: New York, Connecticut and Illinois. In those states, bills are sponsored by majority party members in each house, and the bills are getting hearings, Kink said.

In Illinois, identical bills sponsored by State Sen. Daniel Biss (D-Evanston) and State Rep. Emanuel “Chris” Welch (D-Hillside) would charge a “privilege tax” of 20 percent on partnerships engaged in investment management services until a federal law with an identical effect is enacted.

Based solely on public filings, Hedge Clippers estimates the bill would raise $473 million a year. The Illinois Department of Revenue estimates that the tax has the potential to raise $1.7 billion a year – but the department also argues that the tax would incentivize firms to find new ways to evade taxation or to “relocate taxable activity so it is beyond the reach of the state.”

Welch said he considers this argument a “scare tactic.” “This is what they always say,” he said. “Chicago is a world-class city, and LaSalle Street is a world-class financial center.” Global financial firms are located in a small number of cities around the world – places where they have access to the talent, clients and ancillary services they need. “That’s the reason they are here,” said Welch. “They’re not going anywhere.”….

Kink points out that other kinds of investment firms don’t get this tax break, and they remain in Chicago. “I don’t think it’s a credible threat,” he said. Academic research – and experience with tax surcharges on millionaires – has demonstrated that marginal tax rates aren’t a factor in locating business operations, he added.

In addition, the bill is fashioned as a compact: The tax won’t take effect until New York, New Jersey and Connecticut pass similar measures.

You might expect that Gov. Rauner would veto the bill. And well he might. But he’s heading into a tough re-election campaign, with precious few accomplishments to which he can point…. “It kind of puts him on the spot,” said Kink.

Imagine Rauner taking the moral high ground, calling on his fellow tycoons to pay their fair share – and even to set aside the kind of tax-evasion strategies that aren’t available to the rest of us.

He can afford it, and so can his friends. And soon enough Illinois voters will be deciding whether they can afford Rauner.

Keep your fingers crossed. And if you are in Illinois, Connecticut, or New York, call or e-mail your state representatives and say you expect them to vote for the bill.

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¹ Trump’s tax plan is such a napkin doodle that experts of all persuasions have dismissed it. We need to see at least version 2.0 to see what it amounts to. Even so, Treasury Secretary Steve Mnuchin disputed the idea that the 15% rate would be a huge windfall to private equity and hedge fund managers, so it appears they plan to have some curbs to restrict the largesse. But a separate and much bigger issue is that even in its sketchy form, the tax plan would result in major deficits, and that is unacceptable to the austerity fanatics on both sides of the aisle.