For the last two decades, a regrettable IRS ruling called the “carried interest loophole” has allowed wealthy private equity and venture capital managers to pay a lower tax rate on their income than the rest of us. Fair tax advocates have long called on Congress to close this loophole as a step toward tax fairness. While the prospects for legislation improving tax fairness in Congress have languished this year, the Obama Administration could bypass Congress and take immediate action to close the loophole.
The carried interest loophole has gained even more notoriety in recent years because former Republican presidential nominee Mitt Romney during his time at Bain Capital, resulting in the loophole being nicknamed the "Romney loophole."
The way the carried interest loophole (PDF) works is that managers of investment partnerships such as private equity and venture capital funds are often compensated with a percentage of the profits earned by assets under their management. Because of an unfortunate 1993 IRS ruling, this income is incorrectly treated as capital gains, which means the managers of these partnerships receive the special preferential rate of 20 percent rather than paying the 39.6 percent rate applied to ordinary income. Given the extraordinarily high compensation that many of these fund managers earn, its unconscionable that the tax system allows them to pay a lower tax rate on their income than their receptionists pay.
As tax professor Victor Fleischer noted in the New York Times, to end this preferential treatment of fund managers, all the administration has to do is direct the IRS to reclassify them as service providers, which would require that their income be taxed as ordinary income. Ironically, even some private fund managers have admitted (PDF) in the past that they the work they do should be characterized as "income earned in exchange for the provision of services," rather than as a capital gain.
While there is not an official estimate on the revenue impact that such an executive action would have, the Obama administration's most recent budget proposals include a provision substantially restricting the carried interest loophole and projected to raise almost $14 billion over 10 years.
Over the long term, it would be preferable to end preferential treatment of capital gains, but closing the carried interest loophole would represent a significant step the Obama administration could take now, without congressional approval, to improve fairness in the tax code.