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Business Taxation: What is carried interest and how should it be taxed?

Carried interest is a right that entitles the general partner (GP) of a private investment fund to a share of the fund’s profits (see figure 1). Typically, for a private equity or hedge fund, the GP is itself a partnership that is owned by investment managers and contributes 1 to 5 percent of the fund’s initial capital and commits to managing the fund’s assets. In exchange, the GP receives an annual management fee of 2 percent of the fund’s assets plus a "carried interest" of 20 percent of the fund’s profits that exceed a certain "hurdle" rate of return. The individual partners of the GP, not the GP itself, are taxed on these payments. (In some cases, the general partner may make larger initial capital contributions or assume capital risks prior to the formation of the partnership; this is particularly true for real estate and energy partnerships.)

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Carried interest constitutes on average about one-third of the payments that private equity GPs receive, and the management fee the remainder. Under current law, the management fee is taxed like wage and salary income, with a top income tax rate of 39.6 percent plsu 2.9 percent in Medicare taxes, whereas the carried interest is taxed as investment profit, which often faces a lower tax rate. In particular, any portion of the carried interest that represents qualified dividends or long-term capital gains of the fund is taxed at a top rate of 20 percent plus a 3.8 percent surtax. Many commentators believe it would be fairer and more efficient for carried interest to be taxed like wage and salary income, but others disagree.

  • The amount of assets under management in private investment funds has increased substantially over the past two decades. Private equity funds and hedge funds currently manage roughly $1 trillion in assets each. Private equity funds raised capital totaling about $240 billion in 2006 (see figure 2).
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  • Few if any analysts believe that carried interest represents entirely a return to capital rather than labor. Instead, carried interest has two components: the return on the GP’s financial investment in the fund (the "investment share"), and a return (the "compensatory share") on an amount invested by the limited partners that is implicitly lent to the GP (the "compensatory loan"). The investment share is clearly a return to capital for the GP. Because the GP does not contribute any other capital, the compensatory share appears to be a return to labor.
  • How best to tax carried interest depends on one’s views on several issues. One is the value of the GP’s compensatory share. The compensatory value of a carried interest in 20 percent of a fund’s profits should not be zero. If a private equity GP typically contributes at most 5 percent of the initial assets of a fund, for example, the compensatory share should at least be 15 percent of the fund’s profits. Nevertheless, some believe that the compensatory share of carried interest is relatively small because of the hurdle rate. This seems unlikely given the amount of carried interest payments. (The compensatory share would be lower in cases where the general partner contributes a larger fraction of the initial capital or assumes capital risks before the formation of the partnership).
  • A second issue is what other types of managers or forms of business organization are most similar to, and thus the closest substitutes for, the GP in a private investment fund. Generally, the tax system is more efficient if income earned in two ways that are close substitutes is taxed the same. Observers differ about whether entrepreneurs or investment banks are the closer substitute for GPs. Some view entrepreneurs as closer, because GPs typically start new investment funds on their own initiative and can obtain the same tax treatment as private equity by issuing debt. Others view investment banks as more similar to GPs. Both are business entities, not individuals, and, like GPs, investment banks engage in entrepreneurial activities by starting investment funds. In addition, GPs typically hire from investment banks, not start-ups. Which is the closer substitute matters because not all returns to labor are taxed as wage and salary income. An investment banker’s salary, bonus, and stock options are all taxed as wage and salary income, but an entrepreneur who starts a new business and contributes both capital and labor may, under current law, treat part of the return to labor- "sweat equity"- as a return to capital and not as wage and salary income. This is the case regardless of whether the entrepreneur raises funds for the business by issuing equity or debt.
  • A third issue is the administrability of any potential reform of the taxation of carried interest. If the law were changed to tax the compensatory share as wage and salary income, GPs could still pursue strategies to dilute the tax effects of the reform. As a result, some observers argue that such a change in the law would raise no revenue or would be inadministrable. If these observers are correct, it is unclear why GPs continue to bargain with limited partners to receive carried interest and lobby for retention of its preferential tax treatment. The Joint Committee on Taxation has estimated that taxing the compensatory share like wage and salary income would raise about $15 billion in revenue over five years.
  • A final issue concerns the impact of any future reform on the effective corporate tax rate. Some observers think the current tax treatment of carried interest helps mitigate the unfair double taxation of corporate income. Currently, income earned within a partnership is subject only to the individual income tax, whereas income earned within a C corporation is subject to the corporate tax when earned and the individual income tax when realized or distributed. Some view the corporate tax as necessary to prevent individuals from using corporations as tax shelters; others view it as an unfair and inefficient "double tax." The latter may support taxing carried interest at lower tax rates as a way of reducing the degree of double taxation on a fund’s profits that are from businesses that pay the corporate tax. However, the current tax treatment of carried interest is a very rough solution that only applies in the aggregate, not for individual investments. After all, most C corporations are not owned by private investment funds, and it is unclear what share of private investment fund assets are held in C corporations.
 
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