Is the Billionaire-Creating Carried Interest Loophole an Endangered Species?

An internationally recognized tax expert told me a few months ago that the widely-mislabeled “carried interest” loophole was on its deathbed, that the only uncertainty was how long it would take for it to be dispatched. As much as that is an outcome sorely to be desired, I’m leery of making premature calls of victory, particularly against the plutocratic classes. Nevertheless, the very fact of a PBS video yesterday on this very topic, plus a key aside in it, supports this reading.

First, a bit of background. The reason the “carried interest” label is a misnomer relates directly as to why it is also a tax abuse. Money managers like private equity and hedge funds enter into fee arrangements that include what the IRS calls a “profits interest” and a layperson would describe as a profit share. These firms enter into a prototypical “2 and 20” fee structure, meaning a management fee of 2% per annum of the committed capital plus 20% of the profits, usually after a hurdle rate is met.

Due to clever tax structuring, that 20% is taxed at a capital gains rate even though the managers have no or only a token amount of capital at risk (as in the investors generally require that the fund manager invest some of his capital alongside that of the investors, but it is typically in the 1% to 3% range, and in many cases, that amount isn’t actual cash, but instead a deferral of some of that 2% management fee, which by definition is excessive if the manager is in a position to defer it.*). In other words, they are being taxed at a preferential capital gains rate on what by any commonsense standard is ordinary income and should be taxed at ordinary income rates.

The PBS video below is striking in that PBS is an indicator of leading edge conventional wisdom, and the PBS video signals decline in backing among the elites for this tax dodge. On the one hand, the segment begins with a tiny demonstration against the scheme at a hedge fund conference held at Bloomberg. This could easily have been framed to show how marginal the protestors are. Instead, PBS gave air time to the attractive and articulate leader of the group. And it widens out to show that these opponents have support from an organization called Patriotic Millionaires as well as some straight-shooters in the money management industry, such as hedge fund manager Jim Chaonos.

What was particularly revealing was the stray comment at 4:45: that PBS could find no one in the money management industry who would speak in support of this tax break. Mind you, Steve Schwarzman of Blackstone was so irate about threats to end this loophole in 2010 that he famously compared them to the Hitler invading Poland in 1939.

If you watch the video, you’ll see the only defenders of this tax ploy are from Grover Norquist’s Americans for Tax Reform, which can be relied upon to make extreme arguments for any tax gimmick, and indirectly, the Private Equity Growth Council. But PBS does not have a Private Equity Growth Council spokesman in the segment; it relies instead on a video** which gives a recitation of the party line on the carried interest tax break, which money managers then debunk.

Interestingly, in his effort to defend the carried interest device, Ryan Ellis of Americans for Tax Reform asserts that real reformers, as in those who seek to end this abuse, are interfering with how partnerships were meant to work. In fact, independent tax experts will tell you that partnerships were never meant to be a vehicle for large-scale, impersonal investments. They were envisaged as a mechanism for small ventures and businesses that by nature were owner-controlled, such as law firms, to have a less-burdensome way of organizing themselves from a legal and tax perspective. The US stands apart in allowing the partnership form of organization to be stretched to the degree it has been.

Our tax maven also points out that when (not if) the mislabeled “carried interest” tax loophole is closed, many of the money managers will be able to achieve similar tax benefits by creating a true carried interest, as in borrowing money from their investors to purchase an interest in the fund. However, this would still be a considerable improvement on the status quo, in that the fund manager would lose money if their funds did badly, unlike their current “heads I win, tails you lose” fee arrangement. That should lead them to take less risk, which particularly in private equity, where the private equity managers get rich even when they leave bankrupt companies in their wake, would be a big step in the right direction.

* The management fee is meant to pay for essential overheads and expenses. If the manager can afford to defer some of the management fee to obtain favorable capital gains treatment, it means the investors are letting him get away with getting a higher management fee than is warranted).

**I am not predisposed to notice this sort of thing, but I saw a lot of phallic symbols in the Private Equity Growth Council video. Do other readers see this as a not-sufficiently-subtle effort at subliminal messaging?

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  1. flora

    Thanks very much for this post and video. Paul Solman’s reports are always informative. If PBS is reporting on PE abuses then the topic is entering the ‘conventional wisdom’ stage. That’s good news. NC’s reports on PE abuses have helped mainstream the topic. Thanks for your continuing PE reports.

  2. MikeNY

    The loophole is indefensible.

    When waitresses and bus drivers also get the 20% treatment for their additional ‘sweat equity’ pay, we can think about giving to the hedge fund and PE parasites.

    1. Vatch

      You’re absolutely correct that this loophole is indefensible. I pointed out a few months ago that Paul Ryan, then the chairman of the tax law writing Ways and Means committee of the House of Representatives, opposed any change to this before 2017. Now he’s the Speaker of the House, and as far as I can tell, he hasn’t changed his mind.

      There are bills to change this in both the House and the Senate, and it would be good for people to contact their legislators and ask that they co-sponsor the bills:

      H.R. 2889: only has 5 co-sponsors so far.

      S. 1686: has 9 co-sponsors, including Elizabeth Warren and Bernie Sanders.

      By now, most Naked Capitalism readers who are U.S. citizens or residents should know how to contact their national legislators, but in case a few people have missed that information, here it is:

      Senate contact information:

      How to find your Representative:

      Contact info if you already know who your Representative is:

    2. diptherio

      Our entire tax system is indefensible at this point. Try working as a low-paid independent contractor and somehow figuring out how to pay your end of year 20% tax bill. I care far less about what taxes hedge-fund managers are or aren’t expected to pay, than the taxes that those of us making poverty wages are expected to contribute. The rich are going to stay rich, regardless–the poor are being driven into destitution.

      Made $20,000 this year? Why don’t we knock that down to $16,000… And, of course, the poor tend to have a lot more sense of obligation when it comes to actually paying their taxes, since somehow that has become the test of being a legitimate citizen in many people’s eyes.

      Income tax on anybody making below the median salary is a travesty, and it probably shouldn’t apply to anyone in the bottom 60 or 70%, imho.

      1. griffen

        Income taxes could be collected – but surely on a $20,000 +/- income there are deductions and exclusions (resulting in AGI) that lower the taxable level of income.

        Even on a single earner level you do get deductions. And there should be a refund due.

        1. sd

          Not all expenses are deductible. And depending on where you live, you may have federal, state and city taxes on top of social security. Or those cute little hidden taxes and fees to make up for the lack of local taxes. (New Hampshire property taxes come to mind)

          Been there. Know the pain.

        2. John Zelnicker

          @griffen – You are correct as far is you go. An independent contractor making $20,000 will almost certainly pay no income tax. However, self-employed independent contractors also have to pay their own Social Security and Medicare taxes, both the employer portion (which wage-earners don’t pay) and the employee portion. This amounts to 14.13% of their net business profit (not AGI), before reduction for Standard or Itemized Deductions and the personal exemption(s).

          Also, they are unlikely to get a refund since they have no income taxes or FICA taxes withheld from their paychecks.

          1. griffen

            Point taken. In my simplistic mind, I was not accounting for the self employed or contractor angle of filing the return.

            I’d better stick to lighter + easier thinking for the rest of today.

  3. readerOfTeaLeaves

    Great post – thanks so much.

    Other information relevant to the general topic of tax policy, in quick-to-glance over form of larger patterns, over time, showing the implications of opportunist tax policies that privilege capital by magnitudes over the value of labor — and how that leads to overall economic implosion and social disorder:

    But when the spokesman against carried interest is Norquist’s minion, that’s an encouraging sign.

  4. readerOfTeaLeaves

    One other point – watching one of Norquist’s minions say that Jim Chanos or Morris Pearl or Whitney Tilson don’t know what they’re talking about is absolutely bizarre.

    The day that I claim Chanos doesn’t understand different forms of wealth/money is the day that I ought to be hit by lightning before I get any stupider.

  5. jo6pac


    I love this guy and now the monsters he and his puppet masters created are coming home. The so-called what ever will sell out that’s what they all do once in the beltway. The only way? Corp.

  6. griffen

    Encouraging to see that investors with deep experience like Tilson and Chanos, respectively, are on board with this farce. Great commentary.

  7. RadRandy

    In his analogy, Ryan Ellis equates the “brilliant chef” with the PE firm. That equation I think is quite telling and perversely distorted. Shouldn’t the PE firm be equated with the “brilliant business manager” who needs the participation of the “brilliant chef” in order to run a profitable business? Interesting how labor has no role in Ryan’s plutocrat morality play.

  8. Lune

    I wouldn’t put too much stock in the fact that supporters of the loophole don’t bother appearing on a PBS show. Firstly, people who watch PBS are probably already biased against their position. More importantly, unless that PBS viewer is chairman of the House Ways & Means Cmte, what he thinks means diddly squat. You can be sure that the supporters have been donating plenty of money — sorry Citizens United protected speech — to the people that matter.

    More interestingly is the fracturing of the elites. Carried interest, if I understand it, is primarily a Private Equity thing, which means hedge funds, investment banks, and other rentier elites are finally getting upset about this favorable treatment. When the Feds were showering down trillions in largesse, no one cared about a few billion falling one way or another. But now… Does this mean the slops at the trough are finally getting meager enough that the pigs are starting to compete for every last morsel?

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