How "Carried Interest" May Affect Our Taxes

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A lot has happened since now-president Donald Trump and candidate Hillary Clinton debated on October 9 at Washington University in St. Louis. If you're like most taxpayers, you probably don't remember the candidates bantering about something called "carried interest."

During the debate, Trump was asked what steps he'd take to make sure that the wealthiest of U.S. taxpayers pay a fair share of taxes. Trump responded by saying that he'd eliminate carried interest. What Trump actually meant, though, was that he would change the way carried interest is taxed. Clinton, too, supported making this change. And so did former president Barack Obama.

You can be forgiven if you have no idea what carried interest is. That's because it's something that only benefits the general partners who manage private equity and hedge funds. And most of us can't invest in these private funds because it is so expensive to do so. Investors must usually pony up at least $250,000 to make an investment in one of these funds.

Carried interest is one way that the managers of these expensive hedge funds and private equity funds make a profit. But just because carried interest only benefits a select few, doesn't mean that it's not important to the U.S. economy. According to the Tax Foundation, if Congress taxed carried interest as ordinary income, it could cost the country 2,200 jobs. On the positive side, the Tax Foundation said that changing how carried interest is taxed would also generate about $15 billion during the next 10 years in the form of more taxes sent to the federal government.

What Is Carried Interest?

The best way to understand carried interest is to look at your own investing habits. Say you invest some money in a stock. You hold onto that stock for five years, and its value rises. You then sell the stock and earn a solid profit.

That profit is known as a capital gain, and you have to pay taxes on it. But the tax rate for a capital gain is lower than the tax rate for standard wages and income. In general, wages and salary income is taxed at a top rate of 39.6%. Capital gains, though, are taxed at a top rate of 23.8%.

You can then see that income made from capital gains is even more valuable than the income you make from your salary.

The same basic concept holds true for the managers of hedge and private equity funds. These managers are paid from fees generated by the fund. But they are also paid in carried interest, which is a share of the profits made by the fund. If the fund increases in value, the managers of the fund receive a financial boost in the form of carried interest.

Today, carried interest is taxed as capital gain income, not as salary or wage income. Obviously, this is a nice perk to fund managers, who have to pay less in taxes on carried interest.

How Should It Be Taxed?

During the campaign, Trump said that carried interest should be taxed the same way the country taxes ordinary income. Why? Because carried interest is really part of the salary of a fund manager. So why shouldn't it be taxed that way?

Others, though, make a different argument. The Tax Policy Center cites the common argument that fund managers should not be viewed as typical workers, but rather as entrepreneurs. Entrepreneurs are allowed to treat part of their financial returns as capital, and fund managers should be given the same tax break, according to this argument.

Will Congress ever change the way carried interest is taxed? That's probably not a priority right now. And you can bet that most U.S. taxpayers will remain unaware of what carried interest even is.

But the topic of carried interest might come up again whenever politicians, financial experts, and policymakers debate how the country can make its tax code fair to everyone.