If President Joe Biden’s revenue proposals (the “Green Paper”) for fiscal year 2022 are passed by Congress, fund managers could face increased tax liability. A section in the Green Paper identifies carried interest (or interest on earnings) as the primary source of income for the investment industry. If passed, carried interest – which currently enjoys preferential tax treatment – would be subject to the ordinary tax rate. The proposal also provides that people with high assets or limited partners can also be subject to a new “millionaire tax”.
What is the current law?
With the Tax Cuts and Jobs Act of 2017 (TCJA), Congress took a first step to reduce the benefits fund managers receive from carried interest on the performance of a fund. Under Section 1061 of the Internal Revenue Code, fund managers must now have been in a position for more than three years (previously more than a year) to receive the preferred long-term capital gains tax rate on profits related to their carried interest. This change was primarily aimed at hedge fund, private equity and venture capital managers.
Proposed changes to the tax treatment of carried interest
The current administration plans to further reduce the benefits of carried interest. The Green Paper proposes closing “loopholes” for taxpayers whose taxable income (from all sources) exceeds $ 400,000. It effectively treats the carried interest income as if it were ordinary income.
The highest ordinary income tax rate proposed in the Green Paper is 39.6 percent (2.6 percent higher than the current maximum). If a partner is above the income threshold, a sale of their Investment Services Partnership Interest (ISPI) – a carry interest in an investment partnership – would be taxed at the ordinary income tax rate, not the capital gains rate. At least one thing remains the same, however: Long-term capital gains and qualifying dividend income, which are allocated based on the capital invested – and the percentage of a capital-invested gain from the sale of an ISPI – would continue to be treated as capital income.
Additional taxes managers may face
According to the proposal, carried interest would be subject to self-employment tax (SE tax) instead of net investment income tax (NIIT). This would lead to a further tax increase (the SE tax is an additional 15.3 percent, with half of the tax being deducted as input tax). All in all, the combined federal income tax plus SE tax could increase to around 52.3 percent of the gross income of the carried interest income generated. (This does not take into account the SE tax deduction or the income limits / tax brackets.)
To further increase the tax burden for fund managers, the Green Paper sets a limit of US $ 10,000 for state and local tax deductions (SALT). This means that fund managers living in states with higher income taxes could end up with a tax burden of over 60 percent of their gross taxable income. If the proposal is accepted in its current form, fund managers in New York and California would be subject to income tax liability of more than 65 percent on a gross calculation.
Below is a brief example that illustrates the difference between the current tax law and the proposed tax law. The example shows the maximum individual income tax rates for a New York City-based fund manager who earned a carry of $ 5,000,000 with no other sources of income. Note: The calculation does not take into account the different tax classes or SE tax limits and adjustments.
The above calculation gives an idea of the additional tax burden the fund managers would be subject to if these laws were enacted as proposed. Residents of states with high income tax rates would be subject to an even higher effective tax rate. The SALT restriction, if lifted, could help some taxpayers with the tax burden created by this proposal, but the overall tax rate would still exceed 50 percent for many fund managers.
How are limited partners or capital interest partners affected?
In addition to closing the carried interest loophole, the proposal aims to increase income taxes for anyone with an Adjusted Gross Income (AGI) greater than $ 1,000,000 in any given year. Although the threshold is higher, the Biden government has targeted equity participation in a fund. A limited partner who acquired their interest in the company through a capital contribution could also be subject to normal rates for their long-term capital gains and qualifying dividends if the taxpayer’s AGI exceeds $ 1,000,000 ($ 500,000 for single filers).
Any year in which the taxpayer’s total AGI exceeds the $ 1,000,000 threshold, regardless of tax characteristics, investment income would be subject to the ordinary income tax rate (39.6 percent) plus 3.8 percent net withholding tax. This translates into a rate of 43.4 percent on investment income above $ 1,000,000, which means the benefits of long-term investment or capital lockup would be greatly reduced. It is not clear in the Green Paper how much of the income would go into the higher rates compared to the preferential rate, but the general explanations of the book provide the following example:
A taxpayer with $ 900,000 labor income and $ 200,000 preferential income would have taxed $ 100,000 in capital income at the current preferential tax rate and $ 100,000 at normal income tax rates.
Although we do not know the proposed timing, the new laws would apply to any winnings that are required to be recorded after the “Disclosed Date”. Many believe that this date could be April 28, 2021 when the American family plan was announced.
Summary
After an initial review, the investment industry’s income tax burden will increase significantly if these proposals are passed in their current form. Fund documents relating to tax distributions may need to be adjusted to cope with the increased income tax burdens that fund managers and their investors will face.
For the moment these are only suggestions and do not reflect the final documents that will go through Congress. As with many previous Green Paper proposals, there is still much discussion.
This article was originally published on the Marcum Accountants and Advisors website on August 10, 2021.