Secretary of the Treasury Steven Mnuchin told attendees at the Delivering Alpha conference on September 12 that hedge funds would lose the carried interest loophole under the Trump administration's planned tax reform.
"The president has been clear that for hedge funds they will not have the benefit of carried interest," Mnuchin told the New York audience, adding, "We want to make sure that we encourage jobs."
The loophole allows hedge fund managers to treat their share of funds' profits as capital gains, which are taxed at a much lower rate than regular income. The top rate for long-term capital gains – profits on securities sold after being held for at least one year – is 20%, compared to a 39.6% top rate for regular income and short-term capital gains. High earners are also subject to a 3.8% tax on net investment income, which is associated with Obamacare. (See also, Carried Interest: A Loophole In America's Tax Code.)
Hedge fund managers generally charge a management fee that is paid regardless of performance and taxed as regular income; this is usually around 2% of assets under management. On top of that, they will charge a fee of around 20% of profits above a hurdle rate – most commonly 8%. These "incentive fees" are treated as carried interest for tax purposes and are assessed at the capital gains rate. (See also, Trump's Tax Reform Plan.)
The loophole has long been the butt of criticism, particularly from the left. During the 2016 campaign, Senator Bernie Sanders of Vermont proposed a $5.5 billion youth jobs program to be funded by taxing carried interest as regular income, ending a loophole that "allows billionaire hedge fund managers to pay a lower tax rate than nurses and truck drivers," as his campaign site put it.
The Trump administration has toyed with closing the loophole for some time. Then-Chief of Staff Reince Priebus said as much in April, and Trump hinted as far back as 2015 that he would raise taxes on carried interest, saying of hedge fund managers that "a lot of them, they are paper pushers. They make a fortune. They pay no tax. It's ridiculous, okay?" (See also, What Happens to Hedge Funds If Trump Kills the Carried Interest Tax Break?)
A broad outline of tax reform proposals that the administration released in April did not mention the carried interest loophole, however (which prompted Priebus' comments on the subject). The tax plans Trump released during the campaign would tax carried interest as regular income. But as the Tax Policy Center noted at the time, "...hedge funds and private equity partnerships, which earn a substantial portion of income in the form of carried interest, would qualify for the special 15-percent business tax rate and thus would retain a substantial tax advantage on their income compared with wage earners."
According to the Tax Policy Center, Trump intends to allow business owners to elect a 15% flat rate on pass-through income; currently these earnings are taxed as regular income, with a top rate of 39.6%. Trump also intends to lower the top corporate tax rate to 15% from its current 35%.
No major tax reform bill has been passed since 1986, and the Trump administration faces an uphill battle trying to pass one before the end of the year – the timeline Mnuchin gave at the recent conference. Attempts to repeal Obamacare this summer revealed deep rifts between the White House and congressional Republicans, as well as between conservatives and moderates within the GOP. The current tax code is complex, cumbersome and unpopular, but the benefits of reform are diffuse. Few are willing to fight as hard for overhaul as those who stand to lose their pet carve-outs will fight against it.