What Is Carried Interest and How Does It Affect Startups?

Carried interest, a current tax break that can potentially impact 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 high-profile backers and critics. In 2010, Warren Buffett spoke out against the tax break at a congressional hearing. “If you believe in taxing people who earn income on their occupation, I think you should tax people on carried interest,” he said, per The New Yorker.

Buffett also spoke out against the loophole in an op-ed the following year. However, his tax-the-rich public stances clash with a ProPublica investigation that showed he paid, in effect, a 0.1% tax rate from 2014 to 2018. Berkshire Hathaway did not immediately respond to a 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?

Carried interest is either “one of the most indefensible loopholes in the tax code,” as Senate Finance Committee Chair Ron Wyden, D-Oregon, once called it, or vital to people who help start companies and create jobs, depending on your perspective.

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

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

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

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

Proponents have said it’s a vital break 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 defended carried interest.

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

Why is carried interest coming up now?

Politicians on both sides of the aisle have spoken out against this tax break, and it’s been a topic of conversation since at least 2008. Democrats concluded a drawn-out bargaining process and presented the Inflation Reduction Act of 2022, which relates to drug prices for Medicare and energy issues. It would also raise $14 billion over 10 years by altering the carried interest loophole, per the nonpartisan Joint Committee on Taxation.

According to The New York Times, the changes in the new bill are pretty small. It would increase the holding period — i.e. how long the firm needs to hold onto the asset for it to count for carried interest — for people who make 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 changing carried interest impact startups?

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

Conwell said this is a step towards the ultimate goal, which is probably closing the loophole altogether, which he said would likely hurt his fund a fair amount. Conwell added gets the rationale for taxing massive gains by very large PE firms and felt that tiers, like the one in the bill, to keep changes from impacting smaller investors like himself make good sense.

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