August 20, 2007
Knoll on The Taxation of Private Equity Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income
Michael S. Knoll (Penn) has posted The Taxation of Private Equity Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income on SSRN. Here is the abstract:
Managers of private equity funds usually receive a carried interest - the right to a specific share (often 20%) of the profits earned by the fund - without contributing a corresponding share of the fund's capital and without the obligation to bear any of the fund's losses. Under current law, the managers of most private equity funds pay tax on their carried interests at the 15% rate that applies to long-term capital gains, instead of the 35% rate that applies to ordinary income. Currently, the tax treatment of carried interests is attracting congressional scrutiny, public notice and academic commentary. Critics argue that carried interests are compensation for services and so should be taxed as ordinary income, and possibly also when granted. Yet in spite of the large amounts invested in such funds - as much as $1 trillion by some estimates - no one has much of an idea of the value to fund managers or the cost to the Treasury of the current tax treatment. And the government has not yet released a revenue estimate for H.R. 2834, the House bill that would tax carried interests at ordinary income rates. Accordingly, this essay seeks to contribute to the debate on the taxation of carried interests by developing a method for measuring the additional tax. I then use that method to make some rough estimates of the potential for additional tax collections if managers were taxed at ordinary income tax rates on their carried interests. Finally, I look at how private equity transactions are likely to be restructured if carried interests are taxed as ordinary income, and I speculate on the consequences of such restructuring for tax collections.
Update: Vic Fleischer has more here.
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Perhaps the proposed changes in the taxation of carried interest should be implemented even if, as Knoll argues, the revenue impact is neutral or minimally positive. Tax systems should not only be fair (whatever that means), they should also be easily perceived to be fair.
A few days ago, Richard Murphy argued for repeal of the UK's domicile rule on the BBC Radio 4 program Hecklers despite the fact that his static estimate of the resulting increase in revenue amounted to only "several billion pounds a year." His rationale was that revocation of this tax break for wealthy foreign nationals would bolster the trustworthiness and fairness of the UK tax system.
A similar argument could be made regarding the proposed carried interest changes: if they make U.S. income tax seem fairer and more evenhanded, perhaps they would be appropriate even if they result in little or no increase in revenue.
Posted by: Martin B. Tittle | Aug 27, 2007 12:29:38 AM