What is the carried interest loophole—and what does it mean for VCs and private equity?

Last week, Congress showed that it still had a few surprises up its sleeve for the current session.

In a shocking twist, Senate Majority Leader Chuck Schumer and Senator Joe Manchin announced they had reached an agreement on the Inflation Reduction Act, a scaled-back version of the Build Back Better plan that would address everything from healthcare to the environment to, notably, higher taxes for corporations. To help pay for all that, the agreement included taxing some “carried interest” profits by partners in private equity and hedge funds, as well as venture capital companies.

Closing that loophole would have had a noticeable impact on the private equity market. But on Thursday, the Democrats agreed to drop that provision to win the support needed from Senator Krysten Sinema for the bill to pass the Senate. Here’s all you need to know about carried interest.

What is carried interest?

Carried interest is a share of the profits from a private equity, venture capital, or hedge fund that’s paid to the fund’s investment manager as an incentive. Essentially, it’s a reward for enhanced performance of a fund or portfolio.

What is the carried interest loophole?

While there’s nothing wrong with incentives, what has long bothered people about carried interest is how it’s taxed. Fund managers who receive carried interest (who tend to be among the wealthiest people in the country) get a tax break on that income.

The loophole treats the earnings as capital gains, so they’re taxed at a top rate of 20%, rather than the top tax rate of 37%. That’s especially notable for executives like Blackstone Group CEO Stephen A. Schwarzman, who reportedly earned $610 million in 2020, but was eligible to pay taxes at a similar rate as the average American. (Blackstone has historically refused to discuss Schwarzman’s tax rate, telling the New York Times last year that its senior executives “are among the largest individual taxpayers in the country.”)

Typically, says Law360, general partners of funds earn a 2% fee and a 20% share of profits, while limited partners receive 80% of profits.

The deal struck by Manchin would have required carried interest to be taxed at the higher rate, which proponents said could raise $15 billion over the next 10 years.

Why has it stuck around so long?

The carried interest loophole has been a target of many presidents. Obama pledged to do away with it, but failed. Donald Trump did the same, but was unsuccessful. That’s largely because the private equity industry has spent hundreds of millions of dollars on congressional campaigns. Over the past decade, private equity firms and their lobbyists have given nearly $600 million in campaign donations, according to the New York Times. That buys a lot of favors.

How would closing the loophole affect private equity firms?

A survey of 90 fund managers and lawyers by Private Equity International in 2021 asked what closing the loophole would mean for private equity. Some 81% of those who replied said it would negatively impact their operations.

One of the chief concerns was that it could become less attractive to job candidates (or those currently in the field), with 43% saying it would significantly hurt the profession. Proponents for the loophole also say doing away with it could lower the chances of new investment funds being created.

Lobbying groups for private equity have been speaking out. The American Investment Council wrote in a tweet that “The economy just shrank for the 2nd quarter in a row— Washington should not move forward with a new tax on private capital that supports small businesses, jobs, and pensions across America.”

What will replace the carried interest loophole?

The new bill may now possibly include a 1% tax on corporate stock buybacks.

When will the Senate vote on the bill?

Schumer says he hopes to vote on the bill by Saturday.

This article was originally published on July 28, 2022. It has been updated on August 5, 2022 with information about the Democrats’ agreement with Sinema.