What you pay today
Under current tax law the fund manager earning $1 million would pay $230,000 in income taxes on the carried interest under the current law (an effective tax rate of 23%). This is calculated in two steps. As mentioned, Section 1256 contracts are taxed as 60% long-term capital gain and 40% short-term capital gain and are treated as if sold at year end. So, first multiply the $1 million by 60% and then by the long-term capital gain rate of 15%, which equals $90,000. Second, multiply the $1 million by 40% and then by the highest marginal tax rate for short-term capital gains of 35%, which equals $140,000. Those two amounts together equal $230,000 in taxes on the $1 million carried interest earned.
What you could pay tomorrow
If the proposal to tax carried interest as ordinary income becomes law, the fund manager earning $1 million could pay $373,925 in income taxes on the carried interest (an effective tax rate of 37.4%). This actually is calculated in several steps; however, we will summarize it in two. First, multiply the $1 million by the 35% ordinary income marginal tax rate, which equals $350,000. Second, because this income is now subject to self-employment taxes we must calculate both the employer and employee portions of FICA/Social Security and Medicare taxes. We do make an assumption that the fund manager already does have enough earned income from other sources to be above the FICA tax threshold so therefore only the Medicare tax will be calculated on the carried interest. The net effective tax rate for self-employment Medicare taxes on $1 million is 2.4%, which equals $23,925. Under this latest Levin proposal, the fund manager would pay $373,925 in income taxes on the carried interest for an effective tax rate of 37.4%.
Robert Hartnett, CPA, is a tax principal with Rothstein Kass. He specializes in providing tax planning, consulting and compliance services to a wide variety of investment fund clients.