12 Aug What would killing the carried interest loophole mean to investors?

Q. If the carried interest loophole is done for, will investments with those kinds of managers have higher commissions for investors? Will they try to make up that money somehow for the managers?
— Curious

A. You’re right to wonder if investment managers will quietly take what amounts to a pay cut through increased taxes.

But before we address your question, let’s take a moment to explain what carried interest is, why people are talking about it and how it works.

Carried interest is simply a form of compensation paid to a money manager for his or her services, said Steven Gallo, a certified public accountant and personal financial specialist with U.S. Financial Services in Fairfield.

These managers can be compensated in various ways, such as salary, a percentage of the fund annually, and carried interest, which is a performance bonus calculated as a percentage of the fund’s profit, Gallo said. In most cases, this is the largest component of their compensation package, he said.

Today, the carried interest payout is taxed to the investment manager as capital gains rather than ordinary income, which is a significant advantage for the money manager personally, Gallo said.

“This is the `loophole’ which is under attack,” he said, referring to a provision that was removed from the Inflation Reduction Act last week. It would have helped pay for the bill. “The carried interest bonus is an expense to the fund, so how it is taxed to the money manager has no direct effect on the investment fund itself.”
Gallo said a money manager will look at his or her total compensation package with an eye to after-tax numbers.

“After all, it is not what you make but what you keep that truly matters,” he said. “If a money manager now is required to pay the higher ordinary income tax rate on their bonus, they may demand a higher gross amount from the fund so they continue to net the same amount as they do under the current tax law, which could result in higher administrative costs for the fund.”

Gallo said he doesn’t believe investors will see higher commission rates, but rather, the net return that individual investors may experience may be potentially lower to account for the higher management expense.

“However, I would note that competition within these funds has been growing rapidly over the past several years, which limits how high the administrative costs can go,” he said.

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This story was originally published on Aug. 11, 2022.

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