Research & Commentary: Carried Interest Taxes

Published May 31, 2012

One issue currently under debate is how carried interest, the share of the profits of an investment or investment fund that is paid to an investment manager as compensation, will be taxed. Under current law, when an entrepreneur or private equity, venture capital, or hedge fund firm sells a business or takes it public through an initial public offering, the profits on the sale are generally taxed as a capital gain. 

Capital gains taxes are lower than ordinary income taxes. Ordinary income taxes currently have a top rate of 35 percent, whereas long-term capital gains are taxed at 15 percent. By compensating the investment manager with lower-taxed carried interest, the fund partners give the manager an incentive to work on improving the performance and return on the investment.

Critics of the current tax, including the Obama administration, have moved in the past two years to change these rules by increasing the tax charged on the carried interest earned by these financial firms. Proposed as one of the many tax changes in the American Jobs Act, the new rule would tax profits from the sale of investment management partnerships at the top ordinary income rate of 35 percent.

Critics of the tax increase argued the higher rates are essentially a special tax on financial entrepreneurs. The current lower tax rate on capital gains applies to all industries, whereas the new one would single out private equity and venture capital firms and hedge funds for a heavier tax. They also say this tax increase is a politically motivated move against Wall Street, designed to demonize financial companies for an alleged role in the current recession.

These proposals could have severe consequences if implemented. Hedge funds and private equity are important in injecting new capital into the economy, allowing business expansion and hiring of new employees. These tax proposals would cut incentives for new investment and add to the capital freeze that has been prolonging our current economic stagnation.

John Nothdurft, government relations director of The Heartland Institute, argues that instead of increasing taxes, Congress should be focusing its efforts on creating a tax code that fosters economic growth instead of killing it. “Tax policy that fails to be applied neutrally, broadly, and at a low rate should be avoided. With the U.S. still struggling to crawl out of a recession, the country can ill afford to further hinder capital investments.”

The following articles discuss carried interest from various perspectives.

Capital Gains, Ordinary Income and Shades of Gray
Writing in the New York Times, N. Gregory Mankiw of Harvard University discusses carried interest, how it works, and the proposed changes to how it is taxed.

The Taxation of Private Equity Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income
Michael Knoll of the University of Pennsylvania Law School estimates the tax revenue effects of taxing private equity carried interest as ordinary income rather than as long-term capital gain as under current law. He concludes the expected present value of additional tax collections would be between 1 percent and 1.5 percent of capital invested in private equity funds, or between $2 billion and $3 billion a year. That estimate, however, makes no allowance for changes in the structure of such funds or the composition of the partnerships, which might substantially reduce tax revenues below those estimates.

Two and Twenty: Taxing Partnership Profits in Private Equity Funds
Victor Fleischer of the University of Colorado Law School offers a menu of reform alternatives to current carried interest law, including a novel cost-of-capital approach he argues would strike an appropriate balance between treating returns on human capital as ordinary income and rewarding entrepreneurial activity with a tax subsidy.

Obama’s Tax Policies to Suck the Life out of the Valley
Writing in the San Jose Mercury News, Jim Powell of the Cato Institute explains how the proposed carried interest rate changes could have a devastating effect on investment and the Silicon Valley economy.

Understanding Carried Interest
Alan D. Viard, a resident scholar at the American Enterprise Institute, explains how carried interest works, why it is used, and how it is taxed. Viard argues any changes to the taxation of carried interest should be based on facts rather than populist rhetoric.

A Stealth Attack on Capital Gains
Richard Baker, president and CEO of Managed Funds Association, writes in the Wall Street Journal about the enterprise value tax and how the current efforts to combine it with carried interest tax reform have created what he calls a stealth attack on the capital gains tax.

Taxing Private Equity Carried Interest Using an Incentive Stock Option Analogy
Adam Lawton of the U.S. Court of Appeals for the Second Circuit writes in the Harvard Law Review about the current debate over the taxation of carried interest. He proposes a resolution that is “both moderate and rooted in existing tax code paradigms.”