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How Trump could help Main Street win one over Wall Street

Rick Newman
Senior Columnist

If Donald Trump reflects the zeitgeist, then some of America’s One Percenters are in trouble.

Trump, the bombastic billionaire businessman, has made plenty of enemies since announcing his candidacy for the Republican presidential nomination in June. But one target of his barbs may foretell a rare victory for Main Street over moneyed interests. Trump has singled out hedge-fund investors as one subset of the rich who are “getting away with murder” by fleecing ordinary taxpayers. They’re doing this, Trump claims, by exploiting an arcane tax break that now faces more opposition that it has in years. Trump’s jawboning, in fact, could help close a tax loophole that almost exclusively favors the wealthy and has been impervious to prior reform efforts.

Trump is referring to a tax provision, known as the carried-interest loophole, that allows some financiers to pay a much lower tax rate on certain types of income than if that money were reported as ordinary labor income. And he’s not the only one calling for its elimination. Trump’s Republican rival Jeb Bush wants to close the same loophole, provided there are cuts in other tax rates. On the Democratic side, Hillary Clinton and Bernie Sanders have both decried the tax break as welfare for millionaires. There have been other efforts to roll back the carried interest rule during the last decade, but populist appeal to angry voters across the political spectrum is now generating new momentum to tax the rich.

Trump and others have vilified hedge fund managers as the prime beneficiaries of the carried interest loophole, perhaps because hedge funds are the class-warfare villain du jour. Those who gain the most from the loophole, however, aren’t hedge funds but private-equity firms that pool money from investors such as pensions, university endowments, sovereign-wealth funds and rich individuals, and invest it in privately owned firms where they feel they can turn a profit.

Though obscure to the public, private-equity firms are run by some of the biggest names in finance, such as Steve Schwarzman of the Blackstone Group (BX), Henry Kravis of KKR (KKR), David Rubenstein of the Carlyle Group and Mitt Romney, who founded Bain Capital in 1984 and continued to earn income from its deals even after he left the firm in 2000. Most PE firms are structured as partnerships in which partners split the profits. Many private-equity honcos are big political donors, some of them wired into Washington, D.C. as if they held their own Congressional seats.

The carried interest provision allows the partners at private-equity firms to claim much of their income at the capital-gains rate of 23.8%, rather than the top regular income rate of 43.4%. That lets the partners pocket hundreds of millions of dollars that would otherwise go to the Treasury Department, leaving other taxpayers to make up the difference. “Virtually everybody agrees the carried interest loophole is crazy,” says Steven Rosenthal of the nonpartisan Tax Policy Center. “But nothing has happened.”

One common type of private-equity deal is buying a troubled company, improving its performance and selling it after several years for a handsome premium. Some PE deals save companies that might otherwise fail, but PE firms also draw criticism for saddling target companies with debt that’s mainly used to finance fees paid back to the firm, instead of being invested to improve the core business.

PE firms earn two primary types of income: They typically charge the clients who invest with them a 2% management fee, while also taking 20% of the profits once an investment has met the “hurdle rate” due to investors, typically 8%. It’s that second stream of income that is taxed at lower rates.

Here’s the simple math: On a $1 million investment, the partners at a PE firm would earn $20,000 in fees, with $8,680 paid in taxes at the 43.4% rate. If the investment earns a 20% return, the firm’s take would be $36,800, with that income taxed at a 23.8% capital gains rate, or $8,758 paid in taxes. If that money were taxed as ordinary labor income—as critics insist it should be—the tax paid would be $15,971, or 82% more.

Taxpayers getting 'ripped off'

In general, carried interest is a capital gain earned on long-term investments held more than a year, which means it doesn’t apply to many investing firms that claim profits more quickly, including many hedge funds. Some hedge funds do hold onto assets long enough to get the carried interest tax break, as do venture-capital firms that invest in startups and some real-estate partnerships (possibly including enterprises Trump controls). Still, private-equity firms, which control roughly $3 trillion worth of assets, benefit the most. Tax expert Victor Fleischer of the University of San Diego estimates that private equity firms account for 70% of all income declared as carried interest, with hedge funds, real estate and venture capital accounting for roughly 10% each.

The value of the carried-interest provision is so valuable to PE firms, in fact, that some of them now offer to waive the 2% management fee their investors pay, as long as they can reclaim a like amount from profits. Here’s why: If taken from profits, the income can be declared carried interest and taxed at the lower rate. The cost to investors is the same, while the PE firm earns the same amount—but the partners shift income from the highest tax band to a lower one. “It’s not costing the partners anything,” says Eileen Appelbaum of the Center for Economic and Policy Research. “It’s the taxpayer who gets ripped off.”

PE firms defend the carried interest tax rate by arguing that if it were raised, the partners who lose out would simply charge more for their services, to make up the difference. So the losers wouldn’t be a handful of wealthy financiers but the pension funds, universities and other investors that tap PE funds to invest some of their money. The industry also characterizes efforts to eliminate the carried-interest loophole as part of a left-wing plan to eliminate the capital-gains tax altogether and subject all income to the (usually) higher rates on labor income, which could harm the middle class by forcing ordinary families to pay more when they sell a home or liquidate investments to help fund retirement.

Those arguments may be wearing thin. In July, the IRS said it will no longer allow investment firms to declare management fees as a capital gain taxable at the lower rate. For firms that fail to comply, the IRS said it will invoke its right to audit three prior years of tax returns—essentially, a threat to claw back taxes that should have been paid but weren’t. Still, some critics view the IRS as a paper tiger that has basically allowed PE firms and other complex partnerships to call the shots. In 2014, for instance, the Government Accounting Office found that the IRS’s audit rate for PE-style firms was about one-fourth that of large, publicly owned companies, and that billions in revenue was “misreported” by those firms. “If the IRS would do any enforcement at all,” says Appelbaum, “this stuff would disappear and the American taxpayer would benefit a lot.”

A loophole not worth closing

The government says there’s not much money at stake in the carried-interest debate, which may be another reason the loophole still exists. Congress’s Joint Committee on Taxation, which is bipartisan and generally authoritative, says closing the loophole would bring in just $18 billion over 10 years, or less than $2 billion per year. But Fleischer of the University of San Diego says the Congressional economic model vastly understates the amount of money at stake, which could be $18 billion PER YEAR, or 10 times as much as the government estimates.

Since most PE firms are privately owned, their financial numbers aren’t public, which makes it difficult to estimate how much carried interest financial firms claim. And the IRS hasn’t kept track. But Blackstone and KKR are public, and extrapolating from their numbers, Fleischer estimates that PE outfits and other investing firms earn about $100 billion per year in carried interest taxed at the capital gains rate. If the tax on that income were raised from 23.8% to 43.4%, he says, some of the money would be deployed differently, to avoid the higher tax rate. But tax would still be paid on most of it, with the Treasury netting an extra $18 billion or so per year, he estimates. That wouldn’t be a huge windfall for the government, but it would still be enough to fund NASA, purchase 110 F-35 fighter jets, or cover two-thirds of the cost of an elaborate wall along the southwest border with Mexico, a Trump priority.

Besides, critics of the carried-interest loophole say the most important thing isn’t finding new revenue, but revising the tax code so it seems more fair to ordinary people who think the system is rigged in favor of the rich. “If you fail to cross the Ts on your tax return and the IRS finds out about it, they’re going to hold you to it,” says Gregg Polsky, a law professor at the University of North Carolina. “Imagine if you took your weekly paycheck and called it capital gains by inserting a few magic words into a partnership agreement.”

Rousing words from critics and politicians, of course, are a lot easier to come by than legislation that would actually raise taxes, which seems to be a nonstarter in Washington unless it’s accompanied by corresponding tax cuts or other offsets. That’s why many people who have been pushing for years to end the carried-interest loophole are skeptical that political rhetoric will change anything.

But the IRS rule change will put some limits on carried interest, if the tax agency enforces its own rules. And politicians of both parties acknowledge the need to make the tax code simpler, more efficient and more fair, with the next president likely to make sweeping tax reform an early priority. Lobbyists for Big Finance will undoubtedly fight hard against any changes that dilute profits. But there does come a point in democracies where the pitchforks begin to stir, and the politicians start to listen. That may be happening now.

Correction: This story originally referred to a study by Congress's Joint Economic Committee on the estimated savings from closing the carried-interest loophole. The committee that produced that estimate was the Joint Committee on Taxation, not the Joint Economic Committee.

Rick Newman’s latest book is Liberty for All: A Manifesto for Reclaiming Financial and Political Freedom. Follow him on Twitter: @rickjnewman.