States Explore Taxing Carried Interest

March 6, 2018

The taxation of carried interest is a subject of frequent debate at the federal level. Now, states are jumping into the debate. A number of states, including New York, Illinois, New Jersey, and Maryland, have been discussing proposals to increase state-level taxes on carried interest. Several of these proposals, however, are flawed – regardless of one’s view of how carried interest should be taxed.

For some background: the debate about carried interest focuses on financial arrangements in which an investment manager receives a share of investment profits. Under current federal tax law, these investment profits are classified as capital gains, and are taxed at a top income tax rate of 20 percent. However, many argue that this income is more akin to compensation for investment managers’ labor, and that it should be taxed at a top income tax rate of 37 percent, like other wages and salaries.

In general, the debate about carried interest on the federal level is often overblown, because the actual amount of revenue at stake is relatively small. But the issue has taken on symbolic importance. In fact, the recent federal tax bill contained a minor change to make it slightly harder for investment managers to receive capital gains treatment on their carried interest, requiring managers to hold on to assets for at least three years in order to qualify.

However, some states are hoping to go farther, and have proposed measures to significantly increase the taxation of carried interest.

The New York proposal from Governor Andrew Cuomo’s (D) budget would tax carried interest at a 17 percent rate, to offset the difference between the federal top marginal income tax rate of 37 percent and the capital gains tax rate of 20 percent. The New York proposal is also conditional on the states of Connecticut, New Jersey, Massachusetts, and Pennsylvania passing legislation with “substantially the same effect,” to limit the ability of investment managers to shift their location to avoid the tax. However, the bill is not explicit on what would constitute “the same effect,” and even with that language, it is difficult to imagine that investment managers would not try to relocate their operations to avoid the hefty new tax.

Another issue with the New York proposal is that it may be overly broad, applying the 17 percent surtax on carried interest to C corporations that act as investment managers and to investment management services owned by C corporations. This does not make conceptual sense, because C corporations face the same tax rate on their ordinary income and on their capital gains, so cannot be said to benefit from preferential treatment of carried interest.

The proposals in Illinois and New Jersey suffer from similar statutory language challenges.

The Maryland proposal is slightly different. It would establish a new tax of 19 percent on investment management services. But instead of being conditional on passage in other Northeast states, Maryland’s proposal is a key funding vehicle for its higher education reform package. The package includes free community college for those with less than $150,000 in federal adjusted gross income, among a few other changes. The fiscal note from the state’s Department of Legislative Services illustrates one of the risks of this proposal: the new tax would likely encourage “restructuring of… compensation agreements” to avoid the levy. The new tax is predicted to raise $79 million in revenue in fiscal year 2019, falling to $58 million in fiscal year 2023.  Maryland should proceed cautiously; funding a new government program, such as free community college, from a declining revenue source is a risky strategy.

These proposals suffer from an additional flaw: if carried interest income is categorized as labor compensation when received by investment managers, it should also count as a deductible business expense when paid by investors, a point made in an excellent paper by Donald Marron of the Tax Policy Center. Neither New York nor Maryland provide investors with the ability to deduct the amount of carried interest income paid to the investment managers who will be hit by the new surtaxes.

All in all, even for those who think that carried interest income should be subject to higher tax rates, the New York, Illinois, New Jersey, and Maryland proposals come with significant policy concerns.

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