Senate Legislation Would Close Carried Interest and Derivatives Blended Rate Loopholes in Federal Tax Code

Legislation introduced by Senators Carl Levin (D-MI) and Sheldon Whitehouse (D-RI) would close the carried interest and derivatives blended rate loopholes in the Internal Revenue Code and end the excessive corporate tax deductions for stock options. Title IV of the Cut Unjustified Tax Loopholes Act, S. 268, would ensure that hedge fund managers and other investment managers would pay ordinary rates on all of their income from providing management services.

Taxation of Derivatives. Title VI of the Act would end the blended tax rate for derivatives. Since 1981, profits from derivatives, including commodity futures, have benefited from a more favorable blended tax rate. Specifically, a short term capital gain from these derivatives is taxed, not at the short term capital gains rate, but at a rate which is 60 percent long term capital gains and 40 percent short term capital gains, even if the derivatives are held for seconds. Normally, investments have to be held for at least one year to get preferential long term capital gains tax treatment.

According to Senator Levin, this blended rate loophole lowers the taxes on these derivatives by about 10 percent, which encourages commodity speculation and high frequency trading compared to investments in stocks, bonds, and other financial instruments subject to normal capital gains rules. 

Taxation of Stock Options. Title III of the legislation would end the excessive corporate tax deduction for stock options. Stock options are currently the only type of compensation where the federal tax code allows corporations to claim a bigger deduction on their tax returns than the corresponding expense on their financial statements. That approach enables profitable corporations to report higher earnings to shareholders, said Senator Levin, while using the stock option deduction to reduce or eliminate those earnings on their tax returns and pay little or no taxes.

Corporations are also generally precluded from deducting compensation above $1 million paid to any employee. However, stock option compensation is exempt from that limit. The legislation would ensure that corporations take stock option tax deductions at the time, and in an amount not greater than, the stock option expenses shown on their books; and stock options compensation is subject to the same tax deductibility cap as other forms of compensation.

The Act thus eliminates a loophole that has allowed large corporations to exploit what is in effect a federal subsidy that helps pay for the compensation awarded to their executives. When companies award stock options to their top executives, they are allowed under law to record that expense in two different ways. They report one amount to their investors on their annual financial reports. But they can report a much larger expense, often orders of magnitude larger, to the IRS, and claim a tax deduction for that much larger claimed expense.