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Carried Interests: Revenue Raiser or Continued Fund Management Tool?

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As the US transitions to a new Congress and Administration, the pledge for additional tax cuts will stack up against the promise of fiscal management. Among the debated provisions is carried interests. Some have called it an unnecessary loophole, while others argue that if risk capital is going to be available, this type of advantage is critical.

The core of the debate centers on whether fund managers should benefit from favorable long-term capital gains treatment on their share of a private equity fund’s investment profits or if these performance fees should be taxed as ordinary income.

Current Proposals and Legislative Developments on Carried Interest Taxation 

The Tax Cuts and Jobs Act (TCJA) partially addressed the issue by extending the holding period for carried interests to get capital gains treatment from 1 to 3 years under Code Section 1061. Since that time, there have been numerous proposals to, again, cut back on the carried interest benefit, including bipartisan discussions on the issue held recently in the Senate Budget Committee.  

Democratic proposals include S. 4123, which would require carried interest income to be taxed at ordinary income tax rates; S. 3317, which would tax carried interest at ordinary income rates and prevent fund managers from deferring payment of taxes on wage-like income; and more recently, H.R. 9956, which would “close the loophole” completely, according to its sponsor, Rep. Matt Cartwright (D-Pa.) With the outcome of the elections, these three bills are effectively off the table. However, that does not mean the issue is resolved – further restrictions may be coming. 

Impact of TCJA Extension and Proposed Tax Cuts in 2025

With the election of President Trump and Republican majorities in both the House and the Senate, the extension of the TCJA will have a more straightforward path to completion in 2025. Trump already has conveyed his wish list of tax cuts, including making more provisions of the TCJA permanent, further reduction of the corporate tax rate and easing limits on interest rate reductions. He also wants to repeal provisions in the Inflation Reduction Act, including the corporate minimum tax and the excise tax on stock buybacks. Additionally, he has floated reducing taxes on social security income and tips, allowing deduction of auto loan interest and repealing the $10,000 limit on the state and local tax deduction. 

What will this cost? Extending the entire TCJA for ten more years has been estimated at between $4-5 trillion by the Congressional Budget Office (CBO). The revenue cost of the additional tax cuts proposed by the new President have not been scored, but appear to be substantial. Congress will be under pressure to avoid adding these huge amounts to the deficit, so revenue raisers will have to be part of the negotiations within his own party. While the new Administration plans to impose tariffs to raise funds for tax cuts, tax increases must be in the mix if any reasonable revenue balance is to be reached.  

Another challenge is the distributional effects of any tax changes. The Administration and Congress will face pressure to balance tax savings between high-wealth taxpayers and the middle class. The carried interest provision notably shifts benefits toward those at the higher end of the income scale. 

Carried Interest Tax Changes: Potential $12 Billion Impact and Reform Options 

In 2022, the CBO estimated that taxing carried interests as ordinary income could generate $12 billion over 10 years. Because this provision impacts a relatively small group of taxpayers, it’s often seen as an easy target when Congress seeks new revenue raisers. Here’s what potential changes might involve. 

In a 2022 report, the Congressional Research Service (CRS) offered three options for scaling back the carried interest benefit: 

  • Tax part of a carried interest as ordinary income and part as a long-term capital gain. CRS warns, however, that determining the amount subject to each rate may be difficult.  
  • Extend the holding period to qualify for the preferential capital gains rate. If the holding period is increased, this change could increase the amount of carried interest taxed as a short-term capital gain (a five-year holding period was originally in the Inflation Reduction Act but was removed before passage).   
  • Treat the grant of carried interest to the general partner as a loan from the limited partners made at a preferred interest rate. Then, the difference between an “adequate” amount of interest on the loan and the amount paid would be taxed as ordinary income. Any gains fund managers received from later selling their share in the fund that represents the carried interest would then be taxed at capital gains tax rates. 

Proposed Tax Rate Reductions

There is some support for lowering tax rates on investment income within the Republican Party. Proposals to reduce the top long-term capital gains rate to 15% and eliminate the 3.8% net investment income tax (NII) could bring the tax rate on investment income down from 23.8% to 15%. While the 3.8% NII tax likely doesn’t apply to carried interests due to the active partnership income exception, the reduced 15% rate could still lower taxation on carried interests that meet the 3-year rule, even without changes to the specific provision. However, this could make carried interests more likely to be targeted as a revenue source in the TCJA extension bill. 

Conclusion

When a final agreement on the TCJA is reached, significant funds could be reallocated to other areas of the tax code. However, it’s equally possible that some members of the majority party will resist altering a business investment provision like carried interest. For these reasons, the carried interest provision will be one to watch in 2025. 

Contributors

Lucia Nasuti Smeal headshot

Lucia Nasuti Smeal, Guest Writer

Lucia Nasuti Smeal is a guest writer on tax topics for Frazier & Deeter. She is an attorney, an adjunct tax professor with Georgia State University’s J. Mack Robinson College of Business and with Franklin University and former editor of Tax Notes Today, published by Tax Analysts. Smeal also worked as a legislative analyst for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker and writer on current tax developments. 

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