How Private Equity and Hedge Funds Are Taxed

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How Private Equity and Hedge Funds Are Taxed

Several contentious aspects in the present US tax system favor private equity companies and hedge funds. These specific tax incentives are referred regarded as loopholes by critics, while supporters defend them as a fair way of rewarding risk.

Here is how private equity and hedge funds are taxed.

Key Takeaways

  • Private equity and hedge funds are often organized as pass-through organizations, which allows them to pass on their full tax duty to their investors or limited partners.
  • Individual tax returns are used by investors to record their portion of the fund’s revenue (or loss).
  • Fund managers, also known as general partners, get the majority of their pay in the form of carried interest, which is taxed at reduced capital gains rates.
  • Although these policies have been widely condemned as benefiting rich investors, attempts to remove them have so far failed.

What Are Private Equity and Hedge Funds?

Private equity companies combine investor funds and often use it to acquire and manage existing businesses. They try to raise the value of such enterprises by decreasing expenses and other measures so that they may subsequently sell them for a large profit. A general partner manages private equity businesses, whereas investors are limited partners.

Hedge funds, like mutual funds, combine cash from a group of investors and use it for a variety of purposes with the objective of achieving very high returns. When compared to mutual funds, a more conventional investment, the Securities and Exchange Commission (SEC) observes that hedge funds often use riskier investing tactics, such as leverage, and are not subject to the same disclosure standards. Hedge funds, like private equity funds, are managed by a general partner, and the investors are limited partners.

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Private equity and hedge funds both cater to huge institutional investors and rich individuals who can afford to take on additional risks. To invest in them, organizations and individuals must be accredited investors under the law.

How Private Equity and Hedge Funds Are Taxed

Partnerships, private equity firms, and hedge funds are examples of flow-through businesses (also known as pass-through entities).This implies that instead of being taxed (as companies are), they pass their whole tax responsibility on to their investors, avoiding double taxation. Each year, the fund will provide a Schedule K-1 to limited partners. It calculates their part of the fund’s earnings and losses, which they must record on their individual tax filings.

Limited partners are exempt from paying self-employment tax for Social Security and Medicare since they are deemed passive investors rather than active proprietors. In contrast, revenue from some other forms of pass-through organizations, such as sole proprietorships, is taxed. For example, in 2022, the exemption saves 15.3% on the first $147,000 in income, a possible savings of $22,491.

General partners are taxed differently, and often more advantageously. They generally receive a 2% yearly management fee plus 20% of any profits generated by the fund if specific goals are met. Because of a specific clause in the statute, the 20% is classified as carried interest rather than normal pay, entitling it to advantageous capital gains tax treatment.

The highest tax rate on long-term capital gains, for example, is 20%, whereas the highest tax rate on regular income is 37%. Since the Tax Cuts and Jobs Act was passed in 2017, an investment must be held for at least three years in order to qualify for capital gains treatment. Furthermore, since carried interest is not considered earned income, it is not subject to self-employment tax. In contrast, the 2% management fee is normally taxed as regular income. However, some general partners have found a way around this by using a strategy known as a management fee waiver. They may convert their fee into a capital gain and pay tax at a reduced rate by foregoing their fee in exchange for a larger portion of the partnership’s earnings.

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$14 Billion

According to a neutral Joint Committee on Taxation assessment, the increase in government revenues over a decade would be achieved by taxing carried interest at the same rate as regular income.

Critics and Defenders of Carried Interest

Carried interest is often viewed as a blatant tax benefit for the already wealthy. Both Donald Trump, as a presidential candidate in 2016, and Joe Biden, as the newly elected president in 2021, swore to end it.

The Senate proposed the Ending the Carried Interest Loophole Act in August 2021, but it is still in committee. The bill’s proponent, Senator Sheldon Whitehouse (D-RI), said that “Americans have had enough of hedge fund tycoons utilizing this special carve out to pay lower tax rates than their drivers.” We need to restructure our tax system to prevent the ultra-rich and businesses from evading their fair share.”

Meanwhile, supporters of carried interest argue that abolishing it would be unproductive. According to the US Chamber of Commerce, such a rule would “restrict access to financing, undermining job development and innovation,” among other gloomy predictions.

What is the difference between private equity and a hedge fund?

The main distinction between private equity and hedge funds is in their investing strategies. Private equity often invests in particular businesses, while hedge funds invest in a variety of financial assets. Because of this distinction, private equity has a longer time horizon and may take years to generate a return.

Can anyone invest in private equity or a hedge fund?

Individuals must be accredited investors under federal securities rules in order to engage in a private equity offering or a hedge fund. That implies possessing at least one of the following, according to the Securities and Exchange Commission (SEC) of the United States:

  • Earned income of more than $200,000 in each of the previous two years ($300,000 with a spouse or spousal equivalent), with a comparable forecast for the current year
  • A net worth of more than $1 million (either alone or with a spouse or spousal equivalent), excluding a primary home
  • A valid Series 7, 65, or 82 securities license
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Furthermore, each fund has its own minimum investment requirement, such as $100,000, $500,000, or $1 million.

Can you invest in hedge funds through a mutual fund?

The Bottom Line

Under present US legislation, private equity and hedge funds have many tax benefits that enable them to pay less tax on their revenue than they would otherwise. Despite widespread criticism, these laws remain in effect.

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