Tax Carried Interest as Ordinary Income

The president proposes to tax the income from so called carried interest as ordinary income rather than as capital gains as under current law. Ordinary income is subject to marginal rates up to 35% (39.6% in 2011) while income from capital gains is taxed at a maximum rate of 15% (20% in 2011). 

Carried interest accrues to certain investment fund managers, including managers of hedge funds and venture capital partnerships. These managers generally receive part of their compensation in the form of an interest in the partnership, which entitles them to a share of partnership profits. If the partnership earns a capital gain, the manager reports his share—the carried interest—as capital gain income.  The proposal would treat this as ordinary income on the grounds that for the manager it represents compensation for services, not a return on investment.

Opponents of the provision argue the manager as a partner is entitled to capital gain treatment under general rules for taxing partnerships in which the characteristics of a firm’s income (either ordinary income or capital gains) flow through to partners. The difference, however, is that the manager has not purchased his partnership share, but has instead received this interest as a form of tax-free compensation for services.  The carried interest represents therefore a form of deferred compensation instead of a share in the partnership’s capital gain.

The treatment most consistent with similar transactions would tax the estimated value of the partnership interest when received as ordinary income and subsequent profits as capital gains, thereby treating the manager the same as others who are compensated with shares or other investment interests. However, the IRS has been reluctant to tax a “pure profits” interest (that is the partner has no interest in existing partnership assets at the time the interest is acquired) because of the difficulty of valuing the interest. 

Under the president's proposal, a partner's share of income from a "services partnership interest" (SPI) would be taxed as ordinary income, regardless of the character of the income at the partnership level.  Partners would be required to pay self-employment taxes on income from an SPI.  If a partner sells and SPI, the gain would be taxed as ordinary income, not as capital gain.

Income that a partner earns from capital invested in the partnership would not be taxed as a capital gain provided that the partnership reasonably allocates income across invested capital and carried interest.

Additional Resources
Tax Policy Briefing Book: Business Taxation: What is carried interest and how should it be taxed?

Tax Policy Briefing Book: What are the options for reforming the taxation of carried interest?

Discussion of alternative approaches:
Victor Fleisher,“Two and Twenty: Taxing Partnership Profits in Private Equity Funds.” New York University Law Review 2008.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=892440

Michael Schler, “Taxing Partnership Profits as Compensation Income,” Tax Notes, Vol. 119(8), May 28, 2008.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1136504