TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Tuesday, March 5, 2013

Why Carried Interest Is (and Should Remain) a Capital Gain

NY Times DealBookNew York Times DealBook:  Why Carried Interest Is a Capital Gain, by Steve Judge (President & CEO, Private Equity Growth Capital Council):

The current debates on tax reform and government spending levels have often focused on raising taxes on carried interest. While many, including a recent opinion piece in The New York Times by Lynn Forester de Rothschild, have homed in on carried interest to raise revenue, little discussion has focused on how carried interest actually functions and why it was treated as a long-term capital gain in the first place.

Furthermore, changing the tax treatment of carried interest would not generate the significant revenue needed to close our huge budget shortfall. Some of the latest proposals on carried interest would deprive private equity, venture capital and real estate partnerships of the same long-term capital gains treatment available to other kinds of businesses – and would only pay for merely 3.1 hours a year in federal government operations. ...

Typically private equity investors are paid a 2% management fee, on which they pay ordinary income tax rates, and a 20% carried interest of the partnership’s profits that is only paid after limited partners receive a preferred return of 8%.

Carried interest, therefore, is the profits share on the sale of a capital asset and not “ordinary income” as some would have it treated. In other words, it is a capital gain within a partnership and is rightfully taxed at the long-term capital gains rate — provided that the asset, or company, is held for more than one year.

The aristocratic argument presented by Ms. de Rothschild and others that capital gains treatment should only be available to those with money to invest would advance a policy that puts a higher value on financial contributions than vision, hard work and other forms of “sweat equity.”

The underlying principle is no different than two friends who partner together to purchase a restaurant. One might bring capital and the other brings expertise. The restaurant could be in disrepair or a great concept that needs additional capital to expand. The chef identifies the restaurant to buy and possesses the skills to manage the restaurant and add value to the enterprise over time. The friend has the capital to invest, but doesn’t possess the operational or investment skills to generate a return.

When they sell the restaurant years later, both partners receive capital gains treatment on their long-term investment. A private equity partnership works in the same way. This is Partnership Law 101.

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Mr. Judge's bald declaration that "this is Partnership Law 101" means nothing. The same claim is made by those who desire partnership carried interest taxation at ordinary income rates. As a result, the sophomoric rhetoric stands at a dead even tie.

Where this debate misses the mark is the presumption that capital gains tax rates on carried interest should be boosted up to the ordinary income tax rate. Far better to lower the ordinary income tax rate until it equals the capital gains tax rate.

Posted by: Jake | Mar 5, 2013 5:30:05 PM

What an incredible statement of self-serving tripe. The author deliberately misrepresents the carried interest situation to try and preserve a tax rate for a very wealthy class that results in a less than the effective tax rate of working people.

The carried interest by a sponsor is compensation for services. It is ordinary income. It is not an investment of "expertise" it is simple payment for work performed. The fact that it is contingent on profitability means simply that it is no different than any other bonus arrangement. Capital is not put at risk, and the payments are not a return to capital.

Under the theory in this article all income of management could be taxed as capital gain. The article does do one great public service however, it exposes how greedy those receiving special treatment for carried interest, and how willing they are to distort tax principles to retain their tax breaks.

Posted by: David R. | Mar 5, 2013 6:31:38 PM

it isn't a profits "share" because the profits partners don't own any of the capital on which the profits are earned.

Posted by: stopandlisten | Mar 5, 2013 9:04:13 PM

Remind me again why we give a lower tax rate to capital gains than to ordinary income? Besides generating work for tax lawyers and helping to make the rich richer?

A single rate seems simpler, fairer, and more efficient.

Posted by: Anon | Mar 6, 2013 3:32:43 AM

I suggest that a quick read of the comments in the NYT are worthwhile to gauge how educated readers react to the Judge piece.

Posted by: Bill Turnier | Mar 6, 2013 5:24:49 AM

I too am not that upset about carried interest and see it as based on fundamental principles of partnership taxation. I have a big problem with the fixes proposed - various incarnations of Proposed Code Section 710 which would add about three thousand words to the Code and some new categories to ponder and argue about.

Nonetheless, if it really is such an abuse when it is applied to VC ahd hedge funds, why doesn't the administration attack it by regulation and take entities that are using it abusively out of Subchapter K.

The war against tax shelters has done tremendous collateral damage to ordinary partnerships and legislative action on carried interest will be more of the same.

Posted by: Peter Reilly | Mar 6, 2013 7:29:08 AM

The problem that neither side will admit is that carried interest is not black and white. It's not just like investment of money and it's not just like a regular job.

If carried interest were exactly the same as ordinary income, then sale of any business you build should be taxable as ordinary income. Even if it's Facebook. Then the only way to qualify for a capital gain would be to keep your hands off the business entirely. That would be a stupid tax system, generating inferior growth.

Beware of simplistic answers here. This is a complex question.

Posted by: AMTbuff | Mar 6, 2013 10:40:19 AM