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What are the options for reforming the taxation of carried interest?

 Current law taxes the portion of carried interest income representing a return to labor (the “compensatory share”) as investment income, often at preferential capital gains tax rates. Three alternative approaches would tax the compensatory share as successively more like wage and salary income, which is taxed at ordinary rates: 1) treating the individual partners of the general partner (GP) as if they had received a interest-free nonrecourse loan used to purchase the carried interest; 2) taxing distributions representing the compensatory share as ordinary income; or 3) taxing the value of the compensatory share upfront as ordinary income (see figure 1). Each alternative would likely raise more revenue than current law, but the amount raised would vary.

BT_Fig2_How-could-we-change-the-taxation-of-carried-interest
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  • The nonrecourse loan alternative would tax carried interest income as if the GP’s individual partners received an interest-free loan from the limited partners in order to purchase the portion of their carried interest that was not attributable to any upfront financial investment in the fund on their part. Each individual partner’s hypothetical loan would be treated as if it was secured by this portion of his carried interest and was “nonrecourse” in the sense that the limited partners had no right to pursue his other assets. This approach would have three tax consequences for the GP’s individual partners.
    • Each year, every individual partner would be taxed at ordinary rates on an amount equal to a market interest rate on his hypothetical loan. Under current law, when an individual receives an interest-free loan in exchange for his labor, he is taxed on the interest forgiven as if it were wage and salary income and thus at ordinary income tax rates. The interest rate is not adjusted for whether the loan is nonrecourse but some observers believe it should be.
    • When an individual partner received a distribution representing the compensatory share, he would be taxed on it. If the distribution was a long-term capital gain or dividend, the maximum tax rate would be 15 percent; if it was interest or a short-term capital gain, the maximum tax rate would be 35 percent.
    • Each partner could also claim interest deductions equal to his interest income inclusions. However, as under current law, these interest deductions could only be taken against investment income, not wage or salary income. If the partner’s only investment income was from his carried interest, he could only claim these deductions when he received a distribution.
  • The backend ordinary income option would tax the compensatory share as ordinary income when a distribution was received. The entire compensatory share would then face a top tax rate of 35 percent, rather than the 15 percent rate that currently applies to a significant portion of it.
    • This approach is similar the current treatment of nonqualified stock options, which are taxed as ordinary income when their value becomes ascertainable. Some observers think the compensatory share is similar to such options because it is hard to determine its value in advance and the GP receives some of the gain if the fund performs well but bears no risk of loss.
    • H.R. 2834 (the “Levin Bill”) proposed this approach and the House passed a revised version in H.R. 3996. The Joint Committee on Taxation has estimated that the House-passed bill would raise between $2.0 and $3.2 billion annually over the next 10 years (see figure 2).
    • One potential disadvantage of the backend ordinary income approach is that it would allow GPs to replicate the nonrecourse loan approach by arranging to receive from the limited partners an interest-free nonrecourse loan that had to be used to purchase the compensatory share and was secured by it. Extending the approach to include nonrecourse loans used to purchase carried interest could avoid that problem.
  • Finally, the upfront ordinary income alternative would tax the compensatory share as ordinary income at the time the interest is initially received. If the partner ultimately received distributions worth more than the amount taxed as ordinary income upfront, the excess would be taxed as a capital gain. Conversely, any shortfall would be treated as a capital loss. This approach would mimic the tax treatment of property received in exchange for services when the property’s value is readily estimated. It has received little attention because of valuation difficulties and liquidity concerns.
  • An illustration shows how current law and the three alternatives would work. Suppose that the fund’s initial assets total $100, that the GP is one individual who is entitled to 20 percent of the fund’s profits without having to make a financial investment or exceed the hurdle rate, and that he will manage the fund for five years at which point it will liquidate. The market interest rate is 9 percent. The fund earns a 9 percent return and after five years it distributes a long-term capital gain of $53.86. The GP’s share is one-fifth of that, or $10.77. This implies that the present value of his carried interest at the time of receipt was $7.
    • Current law taxes the $10.77 distribution entirely at the capital gains rate in the fifth year.
    • The nonrecourse loan approach would tax a total of $9 as ordinary income spread over the five years. Assuming he has no other investment income, the distribution of $10.77 would be taxed as a capital gain in the fifth year but would be offset by $9 of accrued interest deductions that he could only claim at that time, resulting in a capital gain of $1.77.
    • The backend ordinary income approach would tax his $10.77 distribution entirely as ordinary income in the fifth year.
    • The upfront valuation method would tax the $7 value of the compensatory share as ordinary income in the first year, and the remaining $3.77 as a long-term capital gain in the fifth year. Thus, the entire value of the compensatory share would be taxed at the ordinary income rate and an additional increment (the return to saving it for five years) would be taxed at the capital gains rate.
    • Assuming a 35 percent ordinary rate and a 15 percent capital gains rate, the present value of the taxes due under these four approaches would be $1.05, $2.62, $2.45, and $2.82, respectively.
  • The revenue effects of these different options would depend to on the accuracy of valuing the compensatory share in the first year, the accuracy of the interest rate applied, and the extent to which individuals receiving carried interest income have other investment income.
    • With accurate valuation, the upfront valuation method would raise the most revenue because it taxes the entire value of the GP’s compensatory share at ordinary income rates in the first year.
    • Many observers believe, however, that upfront valuation would significantly understate the value of the compensatory share. If so, the nonrecourse loan or backend ordinary income approach would raise the most revenue.
    • In the illustration, the nonrecourse loan approach would raise more revenue than the backend ordinary income approach, and substantially more than current law. However, if the interest rate applied was below-market or individuals receiving carried interest income have substantial amounts of other investment income, its revenue effects would be closer or equal to current law.

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