Last wee, Democratic Representative Bill Pascrell, Jr. unveiled H.R. 1658, a legislation that seeks to eliminate a tax loophole known as “carried interest.” The said loophole has been long contended as an egregious privilege bestowed by the country’s existing federal tax codes to wealth managers. As it is, top notch wealth managers or financial advisers earn substantial amounts in managing the wealth of the super rich investors but without paying commensurate taxes.
As Chairman of the House Subcommittee on Ways and Means, Rep Pascrell (D-NJ-09), along with members Rep. Katie Porter (D-CA-45) and Rep. Andy Levin (D-MI-09), introduced a legislation captioned as “Carried Interest Fairness Act 2021.”
In announcing the proposed law, Rep. Pascrell gave the following remarks:
”The credit interest loophole has existed in the country’s tax system for too long; allowing private equity moguls to pay lower taxes than their employees. This year, we will push hard for the closing of that loophole, to ensure millions of Americans are entitled to a fairer tax system as they struggle to survive amidst a system that fails to collect more from those who earn more.”
What Exactly is the Carried Interest Loophole?
The carried interest loophole is one where private equity firms managing the investments of wealthy individuals, usually the ultra-rich, allow the wealth managers to receive a share of the investment returns gained by their client.
Those who support the loophole contend that sharing from the profits incentivize wealth managers to ensure profitability of investments. Since the profit realized by the investment will be carried over as a wealth manager’s investment gains and not as compensation, the latter will pay capital gains tax. The capital gains tax rate is lower than the tax rates imposed on ordinary individual income.
While the country’s existing tax system is supposed to work on the principle that greate tax will be collected from those who earn more, the carried interest circumvents the principle. Under the U.S. tax system, long-term capital gains, usually for investment held more than a year, are levied with lower tax rates.
That being the case, wealth or fund managers can simply put forward recommendations for long term investments for their clients, as a way to ensure that they will be receiving carried interest. However, this is likely to change once the “Carried Interest Fairness Act of 2021″ becomes a tax law.
How The Proposed Carried Interest Fairness Act of 2021 Will Affect the Income of Wealth Managers
Wealth managers are financial advisers who offer a broader range of expert financial services, such as developing strategies and plans in managing the legal, accounting and tax aspects of their clients’ wealth, including giving financial advice on investments and retirement plans.
Under the “Carried Interest Fairness Act 2021” proposed by Democratic Reps. Pascrell, Porter and Levin, capital gains tax on carried interest income will no longer apply, as such income will be subject to ordinary income tax rates. While wealth managers can still apply capital gains tax on investments made with their own money, income earned as share of investments as part of managing the wealth of another, will be subject to ordinary tax rates.
In an article published by Forbes Magazine a 15% carried interest gross returns could be reduced to three percent (3%) once the fund expenses, total management fees and taxes are factored in.
Financial adviser PillarWRM cited similar insights in discussing their published book “The Ultimate Guide To Choosing the Best Financial Advisor” (https://pillarwm.com/ultra-high-net-worth-wealth-management-firms/). It gives advice that when choosing a large firm to manage one’s investments and estate, the financial strategy used by large firms in accounting for wealth management costs and taxes tend to erode the performance gains by chipping off only fragments of the costs.Read More