tax policy center
Tax Topics

Tax Topics

2009 Tax Stimulus
2012 Election Tax Plans
2015 Budget
Alternative Minimum Tax (AMT)
American Jobs Act of 2011
Brief Description of the Model 2013
Camp Tax Reform Plan
Current-Law Distribution of Taxes
Deficit Reduction Proposals
Distribution of the 2001 - 2008 Tax Cuts
Earned Income Tax Credit
Economic Stimulus
Education Tax Incentives
Estate and Gift Taxes
Expiration of the Bush Tax Cuts
Explanation of Income Measures 2013
Federal Budget
Fiscal Cliff
Fiscal Crisis
Flow-Through-Enterprises
Guide to TPC Tables
Health Insurance Tax Incentives
Homeownership
How to Interpret Distribution Tables 2013
Marriage Penalties
Model FAQ 2013
Model Related Resources and FAQs
Payroll Taxes
Presidential Transition - 2009
Recent Tax Stimulus Legislation
Retirement Saving
Tax Encyclopedia Index
Tax Expenditures
Tax Reform Proposals
Value-Added Tax (VAT)
Who Doesn't Pay Federal Taxes?
Working Families

E-mail Newsletter

Enter your e-mail address to receive periodic updates on TPC publications and events.

> newsletter archive

tax topics
 

Budget Header 2011

  Return to Previous Budget Provision                                  Go to Next Budget Provision   
  

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% after 2010) while income from capital gains is taxed at a maximum rate of 15% (20% after 2010).

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 an SPI, the gain would be taxed as ordinary income, not as a 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 reasonable 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: Business Taxation: What are the options for reforming the taxation of carried interest?
Two and Twenty: Taxing Partnership Profits in Private Equity Funds, Victor Fleischer, New York University Law Review, 2008
Taxing Partnership Profits as Compensation Income, Michael L. Schler, Tax Notes, May 28, 2008