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Tax Carried ("Profits") Interests as Ordinary Income

A partner may receive an interest in future profits of the partnership (i.e., a “carried” or “profits” interest) as compensation for performing services for the partnership. If the partnership earns a capital gain, the partner reports his share—the carried interest—as capital gain income. Income from capital gains is taxed at rates up to 15 percent (20 percent after 2012), whereas ordinary income is subject to marginal rates up to 35 percent (39.6 percent after 2012). In addition, income from the performance of services is generally subject to self-employment tax.

Under the president’s budget proposal, a partner’s share of income from an “investment services partnership interest” (ISPI) 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 ISPI. If a partner sells an ISPI, the gain would be taxed as ordinary income, not as a capital gain. Income that a partner earns from capital invested in the partnership and gain on the sale of an ISPI would not be recharacterized, provided that the partnership reasonably allocates income across invested capital and carried interests. A partnership would be considered an investment partnership if substantially all of its assets are investment-type assets (securities, real estate, etc.). The administration estimates that the provision would raise $13.5 billion through 2022.

Proponents argue that income from an ISPI should be treated as ordinary income on the grounds that, for recipient partners, it represents compensation for services, not a return on investment.

Opponents of changing current tax treatment argue that these partners are entitled to capital gain treatment under the general rules for taxing partnerships in which the characteristics of a partnership’s income (either ordinary income or capital gains) flow through to partners. The difference, however, is that these partners do not purchase their partnership shares, but have instead received their interests as a form of compensation for services. No income tax is paid by these partners on the value of these carried interests when they are received. A carried interest therefore represents a form of deferred compensation rather than a share in the partnership’s capital gains income.

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. This approach would treat the manager in the same manner as others who are compensated with shares or other investment interests. However, the value of a carried interest at the time it is received would be difficult in practice to estimate accurately. 

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.