What would the new interest loophole proposal do?

For years, Democrats and even some Republicans, such as former President Donald J. Trump, have called for closing the so-called accrued interest loophole that allows hedge fund managers and wealthy private equity executives to pay tax rates. lower than entry-level employees.

An agreement reached this week between Sen. Chuck Schumer, the Majority Leader, and Sen. Joe Manchin III, a Democrat from West Virginia, would take a small step in the direction of reducing that special tax treatment. However, it would not eliminate the loophole entirely and could still allow wealthy business executives to have smaller tax bills than their secretaries, a criticism leveled by investor Warren Buffett, who has long opposed preferential tax treatment.

The fate of the provision is still unclear given the slim majority Democrats have in the Senate. They would need all 50 Democrats to back the legislation because Republicans have been united in their opposition to any tax increase. But if the legislation passes, narrowing the interest-earning exception would move Democrats one step closer to realizing their vision of making the tax code more progressive.

What is accrued interest?

Accrued interest is the percentage of an investment’s earnings that a private equity partner or hedge fund manager receives as compensation. At most private equity firms and hedge funds, the share of profits paid to managers is around 20 percent.

Under existing law, that money is taxed at a 20 percent capital gains rate for top earners. That’s about half the rate of the top bracket of individual income tax, which is 37 percent.

The 2017 tax law passed by Republicans left treatment of accrued interest largely intact, after an intense corporate lobbying campaign, but narrowed the exemption by requiring private equity officials to hold their investments for at least three years before you get preferential tax treatment on your accrued interest. interest income.

What would the Manchin-Schumer agreement do?

The agreement between Mr. Manchin and Mr. Schumer would further reduce the exemption, in several ways. It would extend that holding period from three to five years, while changing how the period is calculated in hopes of reducing taxpayers’ ability to game the system and pay the lower 20 percent tax rate.

Senate Democrats say the changes would raise an estimated $14 billion over a decade, by forcing more income to be taxed at higher individual tax rates, and less at the prime rate.

The longer holding period would only apply to those making $400,000 per year or more, in keeping with President Biden’s promise not to raise taxes on those making less than that amount.

The tax provision echoes a similar measure that was initially included in the sweeping tax and climate bill that House Democrats passed last year but ultimately stalled in the Senate. The shared interest language was removed amid concern that Sen. Kyrsten Sinema, D-Arizona, who opposed the measure, would block the legislation altogether. Ms Sinema has so far not indicated whether she would agree to any of the tax provisions in the new package. Democrats were essentially betting that she would not block the largest bill for a relatively small change that increases revenue.

Why hasn’t the loophole been closed until now?

Many Democrats have tried for years to completely eliminate the tax benefits enjoyed by private equity partners. Democrats have sought to redefine the management fees they get from partnerships as “gross income,” like any other type of income, and to treat capital gains from partners’ investments as ordinary income.

Such a measure was included in legislation proposed by House Democrats in 2015. The legislation would also have increased penalties for investors who failed to properly apply the proposed changes to their own tax returns.

The private equity industry has defended itself strongly, flatly rejecting the basic concepts on which the proposed changes were based.

“There is no such loophole,” Steven B. Klinsky, founder and CEO of private equity firm New Mountain Capital, wrote in a 2016 New York Times op-ed. Klinsky said that when other taxes, including When they accounted for those collected by New York City and the state government, their effective tax rate was between 40 and 50 percent.

What would the change mean for private equity?

The private equity industry has defended the tax treatment of accrued interest, arguing that it creates incentives for entrepreneurship, healthy risk-taking and investment.

The American Investment Council, a private equity industry lobby group, described the proposal as a blow to small businesses.

“More than 74 percent of private equity investment went to small businesses last year,” said Drew Maloney, executive director of AIC. in private equity that is helping local employers survive and grow.”

The Managed Funds Association said changes to the tax code would hurt those who invest on behalf of pension funds and university endowments.

“Current law recognizes the importance of long-term investing, but this proposal would punish entrepreneurs in mutual funds by not giving them the benefit of long-term capital gains treatment,” said Bryan Corbett, executive director of the association. .

“It is critical that Congress avoid proposals that harm the ability of pensions, foundations and endowments to benefit from high-value, long-term investments that create opportunities for millions of Americans.”

jim tankersley contributed report.

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