I was talking with a client last week and the question of carried interest came up. She mentioned she’d heard the term in the financial press but wasn’t quite clear on the specifics. Let’s take a closer look at this topic that is often discussed for its controversial tax treatment.

What is Carried Interest?

Carried interest (also referred to as simply carry) is the share of profits of an investment paid to that investment manager (most commonly in an alternative, private equity, or hedge fund investment structure). Carried interest is a performance fee, paid out only if certain performance thresholds are reached.

In practice, here’s how it works. These funds establish a targeted rate of return (a hurdle rate). Let’s say it’s 7%. If performance exceeds 7%, all investors must first be paid their promised return. For any returns that exceed the 7%, the investment manager can charge a carry (typically 20%) – with the remaining 80% of the excess profits going to the investors. If performance is below 7%, no carry would come into play. Keep in mind these managers also take a management fee (not dependent on performance), which is typically 2%. This is why these investments are commonly called “2&20” – 2% management fee and 20% carry

Why is it Controversial?

The controversy with carried interest has been less about the share of profits these managers take back from investors but rather about the tax treatment. Carried interest is currently taxed as capital gains rates (20% top rate)- not as ordinary income (37% top rate)- giving the recipients a considerable tax benefit. Giving a tax break to these managers who are exceptionally well compensated (especially in strong return years) has been a tax lightning rod for decades

Where Do Things Stand?

In past tax negotiations, republicans typically lined up in support of the current carried interest tax treatment, while democrats would argue against it. President Trump has flipped that script. Trump has recently come out in support of permanently changing the taxation rules for carried interest, requiring it to be treated as ordinary income. Speculation is the President is seeking offsets if he does in fact work to make his 2017 tax cuts permanent, as well as trying to compensate for other tax promises including no taxation on social security or tip income.

Changing the tax treatment of carried interest could help boost tax revenue by about $100 billion over the next decade, according to the Committee for a Responsible Federal Budget (CRFB), an advocacy group focused on fiscal matters. However, that would only partly offset the wide-ranging tax cuts President. Trump is proposing, which the CRFB estimates will cost almost $5 trillion over the next 10 years.  So needless to say – stay tuned!