Tuesday, March 5, 2013
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.