What Is Carried Interest and How Does It Affect Startups?

Carried interest, a current tax break that can affect startups, private equity and the venture capital community, is back on the national legislative stage in a new bill titled The Inflation Reduction Act of 2022.

The bill has a mix of supporters and high-profile critics. In 2010, Warren Buffett spoke out against the tax break at a congressional hearing. “If you believe in taxing people who earn income from their employment, I think you should tax people for the interest they carry,” he said, per The New Yorker.

Buffett also spoke out against the loophole in an op-ed the following year. However, its tax-rich public stances clash with a ProPublica investigation that showed it did, in fact, pay a 0.1% tax rate from 2014 to 2018. Berkshire Hathaway did not immediately respond to a request for comment. request for comment on how Buffett feels about the current proposal.

Here’s how carried interest works and why it’s important now.

What is carried interest? Is it a tax loophole?

The interest generated is “one of the most indefensible loopholes in the tax code,” as Senate Finance Committee Chairman Ron Wyden, D-Oregon, said, or is vital to people who help start businesses and create jobs, depending on your perspective.

It’s a favorite tax break for private equity firms, where it’s been used to generate a lot of wealth over the years, the Urban Institute’s Steve Rosenthal told NPR on Sunday.

“Some of the wealthiest Americans have made fortunes by earning carried interest, particularly through private equity funds,” he told the outlet.

Essentially, as it stands, carried interest allows venture capital, private equity and hedge fund general partners to pay less tax on a portion (typically 20%) of the company’s investment return, usually if the return reaches at a certain threshold.

The money is then taxed as capital gains, which has a maximum tax rate of 20%. Without this rule, earnings would be taxed as ordinary income, which has a top rate of 37%.

Advocates have said it’s a vital breakthrough to incentivize people to get involved in riskier businesses like startups and create jobs. The US Chamber of Commerce, a business advocacy organization, for example, has long championed the interest.

“Small businesses depend on private equity to grow,” the organization said in a statement on Monday, arguing that this would make PE less likely to invest in small businesses. According to M&A firm Generational Equity’s blog and data from PitchBook, about 45% of private equity deals in 2020 were under $25 million.

Why does the carried interest arise now?

Politicians on both sides of the aisle have spoken out against this tax break, and it has been a topic of conversation since at least 2008. Democrats concluded a long negotiation process and introduced the Cut Act of 2022 inflation, which relates to Medicare drug prices and energy issues. It would also raise $14 billion over 10 years by modifying the interest loophole, according to the nonpartisan Joint Committee on Taxation.

Seconds The New York Times, the changes in the new bill are quite small. It would increase the holding period — how long the company needs to hold the asset for accrued interest to count — for people making more than $400,000 a year from three years to five years.

It would also change “the way the period is calculated in hopes of reducing taxpayers’ ability to game the system and pay the lower 20 percent tax rate,” the outlet wrote.

How will the change in interest affect startups?

Mac Conwell, managing partner at RareBreed Ventures, told Entrepreneur that as it stands, the impact on the early-stage venture fund world would be felt, but not in a major way. Many of his fellow early-stage funds, where the risks are higher, don’t make $400,000 a year, he estimated.

Conwell said this is a step toward the ultimate goal, which is likely to close the loophole altogether, which he said would likely hurt his bottom line a fair amount. Conwell added that he gets the justification for taxing the massive gains of very large PE firms and felt that levels, like the one in the bill, to prevent changes from affecting smaller investors like himself make sense.

“I understand where they’re coming from, but I think the problem is that there’s this idea covered by private equity and what that means,” he said.

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