Private Equity’s Tax Breaks Under Attack

Faced with fiscal challenges to the United States in the last few years, lawmakers and policy experts have discussed eliminating the preferential tax treatment of private equity and hedge funds.  Private equity and hedge fund managers’ annual compensation is often a combination of a management fee and a percentage of profits the fund earns (the latter is termed a “carried interest”).  The management fee is equal to a percentage of the fund’s assets (such as 2 percent), and the carried interest is equal to a percentage of the fund’s profits, such as 20 percent.  Under current law, carried interest is taxed as capital gains.  Long-term capital gains are taxed at a maximum federal tax rate of 23.8 percent (that number includes a 3.8% Medicare tax on such income).  In contrast, the maximum federal tax rate on other income, such as wages, is 41.95 percent (that number includes a 2.35 percent Medicare tax).  Many people argue that carried interest is compensation for services and should thus not be taxed differently than other wages.

President Obama recently criticized the carried interest “loophole,” just as he did during his initial election campaign, and there is a growing belief in the industry that Congress will eliminate it in the near future.