H.R. 4016: Carried Interest Fairness Act of 2012
“The ‘carried interest’ loophole that allowed Romney to pay a 15% tax on his income when he was amassing his fortune at Bain Capital should be one of the first tax dodges to go. Ending it would restore some sense of fairness. Creating a fairer code and reducing the deficit, however, can't be done merely by hiking taxes on a relatively small number of rich people.” – USA Today Editorial: Romney's tax returns symbolize a broken system
On February 14, 2012 Ways and Means Committee Ranking Member Sander Levin (D-MI) introduced the Carried Interest Fairness Act of 2012, legislation to close the carried interest loophole and ensure that income earned managing other people's money is taxed at the same ordinary income tax rates as the income earned by millions of other Americans for services that they provide. Certain investment managers – including private equity managers such as Governor Romney – benefit from a loophole that allows them to pay a 15 percent tax rate on income received as compensation, rather than ordinary income tax rates up to 35 percent that all other working Americans pay.
Why is Congress concerned about this issue?
- Many investment funds are structured as partnerships in which investors become limited partners and the funds’ managers are the general partner.
- The managers often take a considerable portion of their compensation for managing the funds’ investments as a share of the funds’ profits; this profits interest is often referred to as a “carried interest.”
- Where a significant portion of an investment fund’s profits are long-term capital gains, investment managers who are compensated with a carried interest are able to take advantage of the 15 percent capital gains rate on income they receive for the performance of services.
- Essentially they are able to pay a lower tax rate than other Americans on income from their work simply because of the structure of their firm.
- Partnership profits are not taxed at the partnership level; instead, partners are taxed on their share of partnership income.
- That income (capital or ordinary) is determined at the partnership level and “flows-through” to the partners.
What does the legislation do?
- It clarifies that any income received from a partnership, capital or otherwise, in compensation for services is ordinary income for tax purposes.
- As a result, managers of investment partnerships who receive a carried interest as compensation will pay ordinary income tax rates, rather than capital gains rates, on that compensation.
- The capital gains rate will continue to apply to the extent that a manager’s allocation of capital gain income represents a return on capital they have invested in the partnership.
In the case of the sale of manager’s own interest in an investment management firm, the Carried Interest Fairness Act has been reviewed and revised from previous versions to provide that where there is a clearly separable and verifiable element of goodwill, such as where there is a separate management entity, the manager will receive capital gains treatment for that portion of the gain on the sale. The goal is to ensure that all investment managers are treated in a manner consistent with other taxpayers who start and eventually sell a business, and work is ongoing in conjunction with the Joint Committee on Taxation to determine if that standard can be met in other cases.
What kinds of investment firms will be affected?
- Any investment manager that takes a share of an investment fund’s profits as its compensation (i.e., in the form of a carried interest), will be affected.
- This rule will apply to investment management firms without regard to the type of assets they manage, whether they are financial assets or real estate.
This bill serves the broader goal of tax fairness. The principle at work is that compensation for services should be treated as ordinary income and taxed accordingly, regardless of its source. The key issue is the form of compensation (i.e., a profits interest given for investment management services), not the type of assets the firm is managing, its investment strategy, or the amount of compensation involved.
Timeline of Action on Carried Interest Legislation:
June 22, 2007 – Rep. Levin introduces H.R. 2834 to treat carried interest as ordinary income. Original co-sponsors include Ways & Means Chairman Rangel and Financial Services Chairman Frank.
Nov. 9, 2007 – The House of Representatives approves carried interest legislation as part of H.R. 3996, which included tax extenders, an AMT “patch” and other provisions.
June 25, 2008 – The House of Representatives approves carried interest legislation as part of H.R. 6275, the Alternative Minimum Tax Relief Act of 2008.
April 2, 2009 – Rep. Levin reintroduces legislation to treat carried interest as ordinary income (H.R. 1935) for the 111th Congress.
Dec. 9, 2009 – The House of Representatives approves carried interest legislation as part of H.R. 4213, which extended various expiring tax provisions.
May 28, 2010 – The House of Representatives approves carried interest legislation as part of amendments to the Senate-passed version of H.R. 4213.
Feb. 14, 2012 – Rep. Levin introduces the Carried Interest Fairness Act.
Text of the legislation and a technical explanation are available online. Background of the legislation and Timeline of previous legislative efforts to close the loophole follow below. Also included are a Myths vs. Facts document and Key Quotes about the need to address the issue.