In its most recent budget proposal, the Biden administration proposed significant changes to the taxation of income attributable to a carried interest. The proposed provisions are specifically targeted toward general partners of investment funds and would drastically impact the way they have historically been compensated for the management of a fund’s portfolio.
Under the long-standing principles of taxation, the characterization of earnings attributable to a carried interest is based on the type of income earned by the fund. Accordingly, to the extent a fund earns long-term capital gains in conjunction with the sale of a portfolio investment, a portion of the income derived from the carried interest will be taxed at the preferential long-term capital gain rate (0%, 15%, 20%) for federal income tax purposes. Since the earnings are treated in the same manner as the fund and thereby considered investment income rather than compensation (ordinary income), the amounts are not subject to the federal self-employment tax.
Given the carried interest earnings are derived from the performance of portfolio management services, the Biden administration asserts that the earnings should be taxed as compensation rather than investment income. To correct the perceived “unfair and inefficient” tax preference, the administration has proposed to treat all earnings derived from a carried interest as ordinary income, regardless of the income’s character at the fund level.
Accordingly, carried interest earnings attributable to long-term capital gains realized by the fund would be taxed at ordinary income tax rates (maximum rate of 37%) rather than the preferential long-term capital gain rates. Furthermore, the earnings would also be subject to federal self-employment tax which equates to both the employer and employee portion of the Social Security and Medicare tax withheld from wages. The proposed rules would apply to individuals with taxable income of more than $400,000.
All things considered, the changes to the taxation of carried interest earnings are merely a proposal. While consistent with the administration’s proposal from the preceding year, as well as numerous bills proposed by Democratic members of Congress over the past 15 years, enactment of the provision is unlikely at this time given the split control of Congress. However, as reflected by the changes to the carried interest provisions (three-year holding period for long-term capital gain treatment) included in the Tax Cuts and Jobs Act passed at the end of 2017 by a Republican-controlled Congress and President, legislation addressing the perceived “carried interest loophole” has some level of bipartisan support.
With the ongoing debate regarding spending cuts and the expiration of many provisions within the Tax Cuts and Jobs Act at the end of 2025, the provision could garner increased attention as a revenue raiser to fund spending or tax cuts. Our team will continue to monitor the progress of the proposal; in the meantime, please do not hesitate to reach out to us if you have any questions.
