The origin story of the carried interest tax break (or carried interest tax loop : Planet Money – NPR

In the game of congressional dysfunction bingo, I would propose that just maybe the free space in the middle should be the three words that seem to come up over and over and cause problems for Republicans and Democrats. It is the carried interest loophole.
The carried interest loophole – it’s a tax thing, a tax break. We’re going to keep saying loophole because that’s how it’s become known. But it is a way that wealthy people – often people who manage things like hedge funds, venture capital firms, private equity companies – a way that those people are able to pay lower taxes. Specifically, it lets them say, you know, like, no, no, no, my money coming in here isn’t income, which has a high tax rate. It’s this other thing called carried interest that has a much lower tax rate.
CHILDS: And the Inflation Reduction Act – nay, the climate bill, nay, also, Build Back Better – was going to sort of close this loophole – or, like, start to think about closing it. But then, Arizona Senator Kyrsten Sinema made her fellow Democrats take it out.
MALONE: But, you know, all of this got us thinking that a tax loophole – it does feel like this thing that’s born of a conspiracy hatched over expensive steaks with butter on them. And I mean, maybe it’s not not that, but in the case of carried interest, it is so much more than that. The carried interest loophole in particular is the result of decisions and indecisions and literally 1,000 years of history.
MALONE: Hello, and welcome to PLANET MONEY. I’m Kenny Malone.
CHILDS: And I’m Mary Childs. Today on the show, we chase the carried interest loophole across time and space to bring you some of the greatest moments in carried interest history – three vignettes that explain how we ended up where we are today.
MALONE: It is a proper epic. We’ve got medieval ships and pirates. We’ve got the great tax dodge free-for-all of the 1950s, and we’ve got a genius artist whose medium is the tax code.
MALONE: OK, carried interest loophole – today, we want to show you how America’s favorite tax loophole was kind of assembled piece by piece over time. And to show that, we are going to travel to three of the great moments in carried interest loophole history.
CHILDS: Great moment No. 1 – the creation of carried interest – no loophole yet, just carried interest.
CHILDS: The year was ’63, and topping the old charts was everybody’s favorite – Moshedarai (ph).
MALONE: Yeah, of course, we are in the year 1163. There is apparently a golden age of Hebrew poetry in Islamic Mediterranean countries – hence this poem.
CHILDS: But also in the Mediterranean in the 1100s, there is more and more commerce.
FRANCESCA TRIVELLATO: My name is Francesca Trivellato. I – do you want me to say more about my profession?
MALONE: Yeah. Francesca is at the Institute for Advanced Study – she’s a historian – and she knows boatloads about boatloads, like medieval shipping and trade. And Francesca thinks our carried interest origin story very likely begins earlier. But it’s really starting to become commonplace in the 1100s in Mediterranean shipping.
TRIVELLATO: So say you’re in Alexandria, in Egypt.
TRIVELLATO: And you have a shipment of pepper…
TRIVELLATO: …To send to Venice.
CHILDS: In the 1100s, the Mediterranean Sea was like an enormous flea market. You had a bunch of ships bopping around from Egypt to Greece to Italy. And Francesca says the merchant would get off and sell or trade whatever they had – for example, pepper.
MALONE: Is pepper a – is it fancy, or is this just, like, a spice…
TRIVELLATO: It’s a luxury good, yes.
MALONE: OK, a luxury good.
TRIVELLATO: Right in the Middle Ages, people had very sophisticated culinary tastes.
MALONE: So I’m imagining ships full of pepper, spices – I don’t know – perfumes, perhaps? Are these wonderfully smelling ships that we’re on?
TRIVELLATO: I think anything before very recent time was very smelly.
MALONE: (Laughter).
CHILDS: So we’ve got a bunch of stinky ships bobbing around the Mediterranean Sea.
MALONE: And Francesca says this is the 1100s Mediterranean Sea, where there’s a much higher risk of shipwreck and a higher risk of other bad things.
TRIVELLATO: Pirates, you know, sickness, drunkness (ph), mutiny.
MALONE: And it is from this commercial, risky slurry, Francesca says, that we can see carried interest really emerge.
CHILDS: Here is the basic situation. Our pepper merchant – let’s say he’s been at this for 20 years, done quite well. And he’s starting to think, do I really want to leave my family again, get on this boat for weeks and weeks, and sell things at port, what with all the drunkenness and the mutiny and the smell?
MALONE: Yeah, sure. And so, you know, the merchant of pepper must find someone else to do all of that – a family member, a younger merchant, maybe even a ship’s captain who wants a little side hustle.
CHILDS: Whoever it is, this new traveling merchant – they’re going to be taking lots of risks.
MALONE: Plus, for the older, rich, back on shore merchant, this new arrangement does introduce a whole new kind of risk.
TRIVELLATO: Complete incompetence – I mean, the guy can just sell the goods and disappear from the face of the earth.
MALONE: Right.
TRIVELLATO: So the traveling merchant need to have some interest in his future career.
MALONE: Right, yes, that’s right. There needs to be some incentive for the traveling merchant to not sell all of this pepper and then just peace out and…
TRIVELLATO: Take the money and run, yes.
CHILDS: And one solution that seemed to emerge was this The stay-at-home merchant would promise the traveling merchant a share of the pepper profits – maybe even half of the profits.
MALONE: Sure, that guy could still run away, but it’s probably better business in the long run to be good and keep doing these trips and keep getting a cut of those pepper profits.
CHILDS: And this – this cut of the pepper profits – this is a version – maybe one of the very early versions – of what we now know as carried interest.
MALONE: Is it carry, like, is it as simple as, like, you’re carrying goods, who, like…
TRIVELLATO: That’s beyond my speculation ability.
MALONE: Beyond your – totally fair.
TRIVELLATO: I was hoping to find out by listening to PLANET MONEY.
MALONE: Oh, no (laughter).
CHILDS: I mean, it makes sense – right? – like, carrying stuff, interest, skin in the game, you know?
MALONE: Yeah. Email us if you’ve got better etymology. But yes, carried interest is a profit share given in a shared risk-taking venture. And this first shows up in shipping arrangements, and it shows up again and again in history.
CHILDS: Francesca had a theory that, even back then, carried interest may have been controversial. In the 1100s, the question would have been, hang on, is this carried interest arrangement actually a secret kind of loan?
MALONE: Yeah. Yeah, loans – loans with interest, particularly – were a big deal. In early Islamic and Christian and Jewish societies, loans were a big no-no, as in illegal. And, you know, if you really hate loans, there is a case that carried interest looks a little like a loan.
CHILDS: Right? You’ve got the old rich merchant, and is he not kind of loaning all of his pepper to the young merchant?
MALONE: Yeah, and then, you know, the young merchant has to pay him back plus profits.
TRIVELLATO: Any sum repaid in addition to the principal on a loan is usury.
MALONE: Usury meaning illegal loaning, basically – even if your principal is a bunch of pepper. It could count.
CHILDS: So Francesca suspects that this carried interest arrangement had to be carefully labeled – like, no, no, this isn’t a loan. This is a partnership – two merchants just trying to make it in this stinky, wrecky (ph), risky business.
TRIVELLATO: And therefore, the amount of money that the resident merchants invested and the forms of rewards that both he and the traveling agent were entitled to were understood as a form of shared risk. In that way, the charge of usury was bypassed.
MALONE: Now, over the next thousand years, a lot of really smart people would spend a lot of really smart time finding their own ways to carefully label this carried interest arrangement. Which brings us to…
CHILDS: Great moment in carried interest loophole history No. 2 – the loophole part of the carried interest loophole.
MALONE: And to be clear, this isn’t just about carried interest. This is really about how the tax code wound up riddled with exemptions and carveouts and – yeah, sure – loopholes, if you will.
STEVEN BANK: I’m Steven Bank. I’m the Paul Hastings Professor of Business Law at UCLA School of Law.
CHILDS: Steve specializes in tax law – used to practice it.
BANK: I’ve written a lot about the democratization of tax avoidance in the ’50s and ’60s – you know, when did tax avoidance become respectable?
MALONE: When did tax avoidance become respectable? The year is 1950s.
BUD ABBOTT: You have the brain of a low-grade moron.
MALONE: Comedians Abbott and Costello are considered funny and have been doing a surprising number of taxation bits.
ABBOTT: Got to get rid of that $3,000 or we’ll have to pay income tax on it.
LOU COSTELLO: I wonder how I can get rid of this money.
ABBOTT: Wait a minute, I’ve got it. We’ll give $1,000 apiece to the first three people we meet.
MALONE: That is tax avoidance.
CHILDS: It’s pretty amazing.
MALONE: So one might ask, why are there arguably funny bits about tax at all in the 1950s? And, well, leading up to 1950, there had, of course, been decades of wars. And to help pay for those, personal income taxes in the United States had gone up and up. And the top tax rate in 1950 was 91%.
CHILDS: So if you were a really rich person, there’d come a point where every time you earned a new dollar, you kept 9 cents and gave 91 cents to Uncle Sam.
MALONE: And yet – and yet Uncle Sam, i.e. politicians, they didn’t necessarily want all of this. They didn’t want these wartime rates, but they were scared to cut them because it would look like a break for the rich.
BANK: At that time, that was, like, kind of embarrassing. So Eisenhower didn’t want to – nobody wanted to lower the top rate, but they all recognized that the top rate was outrageous. So the way to deal with that without lowering the top rate was to provide a lot of exemptions, to overlook a lot of things.
MALONE: As in overlook some of the creative ways that rich people might try to avoid paying taxes.
CHILDS: So we’ve got this huge incentive to avoid income tax and politicians willing to look the other way. The 1950s had the perfect conditions for a tax-avoidance bonanza.
MALONE: So rich people call in the tax lawyers and the accountants who basically, you know, had two main tools. No. 1, asking for those exemptions or deductions or deferrals, that was a big one – getting special language in the actual tax code. It was like tax Oprah. You get a tax break. You get a tax break. You get a tax break.
CHILDS: One infamous example – somehow, the tax code ended up with a tax break for, like, film executives who happened to leave their jobs but had been there for 20 years and happened to have held profit shares for 12 of those years. And everyone was like, wait, this only applies to L.B. Mayer – you know, the second M in MGM.
MALONE: It was good to be a rich person with tax people. And tool No. 2 that they got access to – capital gains conversion. Capital gains is the tax-y (ph) way of saying money you make when you sell something like property or an investment. And if that sounds vague, maybe usefully vague, then you might be a great tax lawyer because, you know, what is capital gains versus personal income, really?
BANK: So just to use a simple example – if I sell you tax advice, you pay me; that’s ordinary income. What if I write a book on how to avoid taxes and then I sell the rights to the book to somebody else – right?
BANK: So I’ve sold the rights. I haven’t sold the book. Like, I’m selling intellectual property, right?
BANK: Can that be now capital gains ’cause I’m selling an asset? Right? Rather than – you know, I’m not selling, like, copies of it.
MALONE: So, you know, there are ways to convert personal income-y (ph) stuff to capital gains-y (ph) stuff. And you might have wanted to go through all of this trouble in the 1950s because the top rate for personal income, again – 91% as opposed to 25% for capital gains.
CHILDS: So creative tax solutions became a superhot industry. Today, people sometimes complain that, like, our best and brightest end up working just to make Facebook marginally more addictive or whatever. Well, in the ’50s, people had the same complaint except it was about geniuses helping rich people avoid taxes.
BANK: Large portion of the tax industry was devoted to conversion. If you could just recharacterize – didn’t even have to…
MALONE: Conversion meaning, can you call all this money that I’m getting this other thing? And problem solved.
BANK: Exactly.
MALONE: This moment in time, the early ’50s, it does feel like maybe the tax system could have gone another way. Like, if everyone thought 91% personal income was too high, maybe our politicians could have just banded together and courageously cut taxes for the rich.
CHILDS: But nope. Instead, they let the uber-wealthy hire expensive lawyers and accountants to chisel and chisel away at their taxes until, finally, Congress and the IRS were kind of like, all right, maybe it’s fairest to open up all of these tricks for everyone, or at least more than just the uber-, uber-rich.
MALONE: And so in 1954, we got a huge restructured tax code that sort of just spelled out lots of the tricks rich people were using and said, yeah, yeah, here you go. Here’s a bunch of rich people tricks. They’re fine. Have at.
CHILDS: Have a good time, kids. Don’t do anything I wouldn’t do.
BANK: If 1954 enshrined anything, it’s – the entire code was replete with examples of people lobbying for specific provisions that would allow them to capture the capital gains rates. It’s what everybody was doing at the time.
MALONE: I like to imagine that the tax code went from a nice, thin slice of American cheese to a big, old block of Swiss cheese – holes everywhere. And in that 1954 code was Section 702, which says, quote, “income and credits of partner in determining his income,” etc., etc. It’s very hard to read, but apparently, this stuff matters quite a bit.
CHILDS: Because that amalgamation of words apparently says, hey, friend, if you happen to get paid through one of those stinking, medieval carried interest arrangements, you can go ahead and apply that sweet, sweet capital gains tax rate.
MALONE: A little carried interest tax break right there in the code. And who would have been using this in the ’50s? Oil and gas, film industry, ranching – these are places where people are partnering and sharing risk. But…
MALONE: One person would take that little break to the exact right place at the exact right time to make the big carried interest loophole that we know and love today – after this break.
MALONE: OK. Final, great moment in carried interest loophole history – this is the big one, the moment someone pulls it all together.
CHILDS: Our final stop is the early ’60s.
THE BEACH BOYS: (Singing) If everybody…
MALONE: Yes, the 1960s this time – 800 years later and golden era of Hebrew poetry is out. “Surfin’ USA” is what we get now.
THE BEACH BOYS: (Singing) Like Californ-I-A.
CHILDS: This final chapter is probably the early 1960s. We don’t know the exact date.
MALONE: But we think we do know the exact person at the center of this.
CHILDS: It’s Valentine with a V?
SEBASTIAN MALLABY: Yes, Valentine like Valentine’s Day.
CHILDS: This is Sebastian Mallaby. He’s a journalist and has written some very big books on finance including one called “More Money Than God.” It’s the definitive history of hedge funds. And while he was researching for that book, he was tracking down partners in the very first hedge fund.
MALLABY: And as I went around talking to all the partners who were still alive, I kept on hearing this name – Richard Valentine, Richard Valentine.
MALONE: Richard Valentine was a tax attorney in New York in probably the early 1960s. Notably, though, he was advising on those early hedge funds. Now, he died in 2003. But I will say I’m not sure I’ve ever seen an obituary quite like Richard Valentine’s. His firm paid to put it in The New York Times, and they described him as, quote, “a brilliant tax attorney” and, quote, “among his many innovations was the offshore structure, parentheses, which is now commonplace, close parentheses.”
CHILDS: They seem to be claiming that he invented the offshore tax shelter. Congratulations to him.
MALLABY: I tracked down one of Richard Valentine’s proteges who was still practicing tax law in New York. And he told me how, first of all, Valentine was this, like, off-the-wall creative genius who could be completely absent-minded, but kind of (inaudible) inspired.
CHILDS: He was inspired. Richard Valentine was an artist, and his medium was tax structuring. So sometimes, he came off as a bit eccentric or intense. Like, there’s this story about how he called a colleague’s home one day.
MALLABY: And before, you know, waiting for the other person on the end of the line to say hello or anything, he would – so I’ve got this new idea, and I have just been thinking about it, and I think we can really structure this tax situation in your favor. And he would give into this long exposition. And after a while, there would be this child’s voice on the other end of the line saying, I’ll get my daddy. He was talking to his colleague’s 5-year-old.
MALONE: Sebastian says that Richard Valentine, this innovative tax genius – that he was working for that first hedge fund when the big carried interest moment happened. It’s when they asked him to optimize their tax mitigation strategy or whatever the words they would have used were.
CHILDS: And for a tax artist, this 1950s Swiss cheese tax code would have been everything you’d ever need – it’s your paint, your paintbrush, your palette knife, your canvas – because the tax code was now so full of exemptions and carve-outs and ways to convert things to capital gains. And Richard Valentine found the perfect thing for his hedge fund client.
MALONE: So for context here, the way this early hedge fund worked is that, you know, they would take a bunch of money, largely other people’s money, and then make a bunch of bets on companies.
CHILDS: There are a few ways you can compensate yourself for managing people’s money. You can pay yourself a salary or a management fee for doing the job of managing the money – reasonable.
MALONE: You know, you can also pay yourself a bonus for doing such a good job for getting good performance. Like, that’s all quite reasonable.
CHILDS: But paying yourself in those ways would generally be just income, just ordinary income for doing work like a pleb. And you’d get taxed like a pleb at that high, ordinary rate.
MALONE: Richard Valentine, though, looked at the tax code and spotted another option.
MALLABY: If you gave yourself a bonus as a money manager, you would pay the income tax rate, which is 91%. But if you called it a performance reallocation – so you were just sort of sharing in the performance of the capital invested – then that would be capital gains tax, which was only 25%.
MALONE: Now, maybe Richard Valentine called it performance reallocation or whatever, but Sebastian says this was it, the moment the carried interest loophole was applied to the financial investment industry.
CHILDS: Valentine’s implied argument here was that a hedge fund manager isn’t really earning income. They’re not some salaried worker at the fund.
MALONE: No. No, no. In fact, it wasn’t that different from our medieval pepper merchant of Alexandria. This was like saying that the hedge fund manager is sharing in the risk of the fund. They’re all on the same smelly, risky investment ship together in a carried interest arrangement.
CHILDS: And if that was true, then, according to the 1954 Swiss cheese U.S. tax code, voila. Suddenly, your hedge fund manager only has to pay the government 25% instead of that income tax rate of 91%.
MALONE: And there you are 800 years later – more relabeling around carried interest. You just peel off that little sticker that says hedge fund bonus and stick on a new one that says performance reallocation. And eventually, people would just end up calling these payments carried interest, or carry for short.
CHILDS: For a tax lawyer, this sticker swap is your Sistine Chapel. This is probably going to be your best idea ever – well, this and apparently offshore tax shelters.
MALONE: It’s a big one. It’s a big one.
MALONE: Now, this loophole did not hit the mainstream for a while, and that was by design, Sebastian says. He remembers talking to one old-school hedge fund manager.
MALLABY: He said to me – and I quote him here – “everyone in the hedge fund business who knew about this arrangement was very quiet about it for 10 or 20 or 30 years.”
MALONE: Sebastian says they didn’t want the IRS or politicians, like, look in too closely. But word did spread – hedge funds and venture capitalists and private equity…
CHILDS: Mmm-hmm. That’s right.
MALONE: Yeah, yeah. And, well, as their industries grew, they, too, would use the carried interest loophole.
CHILDS: And the argument, or rationalization, for the carried interest loophole in hedge funds and venture capital and private equity is that the government wants people and money to invest in good ideas – in startups that are really risky today but will one day do something that may benefit society. You should be encouraged to take that risk with a promise at the end, that you’ll get to retain more of your profits for having been so brave. So I asked Sebastian, does this seem like, OK, we want to encourage investment? We want to encourage, you know, risk-taking. Is it still doing what those things are? Like, is it functioning in the way that we want?
MALLABY: Broadly, no. So I think the judgment is pretty easy on private equity and hedge funds, that the people who run these partnerships get paid a huge amount of money. And so they’re delighted to be taking this bet, and we don’t need society to give them a tax break to encourage them to do that.
CHILDS: Sebastian gave slightly more allowance for it in venture capital because he thinks that tech startups are the best way to turn scientific ideas into real, useful products. And he thinks the loophole probably does help create a bit more innovation, which is good, but not enough to justify the resulting inequality.
MALONE: And, you know, we probably should mention that a lot of tax breaks in general, this one included, did come about during that time when personal income tax rates were really, really, really high from wars. And those income tax rates are not that high anymore. And a lot of people think it’s maybe time to start tidying up the tax code a bit. In fact, both Democrats and Republicans for, like, the last 15 years have been talking about killing the carried interest loophole – in 2007, and in 2012, 2016, and now, again, in 2022. But it keeps surviving.
CHILDS: And, you know, probably, the reason has to do with entitlements are really hard to get rid of. And parts of the financial industry have managed to organize really well and have a lot of lobbyists.
MALONE: Or, Mary…
MALONE: Maybe it is something bigger, more philosophical. Maybe it was inevitable. Maybe, maybe it is that the carried interest loophole is on a galactic journey. Maybe it crawled out of the primordial ooze of commerce in the Mediterranean and just evolved into its natural state.
MALONE: We’ll be back here in two years to talk about this again when they try to kill it again. Have a good night, everybody.
CHILDS: You can email us at or find us on TikTok, Facebook, Twitter or Instagram. We are @planetmoney.
MALONE: Our show today was produced by Dave Blanchard. It was edited by Jess Jiang and mastered by Debbie Daughtry. PLANET’S MONEY’s executive producer is Alex Goldmark.
CHILDS: Special thanks to Daniel Estrin and Daniel Trefler.
MALONE: The Daniels. The Daniels. Yes.
CHILDS: If your name is Daniel, thank you.
MALONE: Yeah, thanks.
CHILDS: I’m Mary Childs.
MALONE: I’m Kenny Malone. This is NPR. Thanks for listening.
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