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Friday, June 28, 2013

Kahn & Kahn: In Defense of the Current Tax Treatment of Carried Interest

Tax Analysts Jeffrey H. Kahn (Florida State) & Douglas A. Kahn (Michigan), In Defense of the Current Treatment of Carried Interest, 139 Tax Notes 1203 (June 3, 2013):

The Obama administration and several commentators have asserted that the current taxation of so-called ‘‘carried interest’’ at capital gains rates is wrong and unjustified. Their case for this change is based on their characterization of the distributions to the partners in question as payments for their services. If that characterization were correct, there would be a very strong case for ordinary income treatment. This letter to the editor explains that, to the contrary, that characterization is erroneous. When the nature of the transaction is examined, it is clear that capital gain treatment is entirely consistent with tax policy and is appropriate.

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What is the consistent tax policy that requires lower taxation of wages of such a specific sector while everybody else who does the same thing is taxed differently? There is none. This is inconsistent with common sense and basic fairness and therefore cannot be justified and definitely cannot be consistent with any genuine tax policy.

Posted by: Yariv Brauner | Jun 28, 2013 11:43:10 AM

As we noted in our letter, superficially it would seem that wealth created by a person's labor should be taxed at ordinary income rates. But the situation becomes more complex when the wealth is created by a blending of capital and labor. In such cases, rather than attempt to attribute a portion of the increase in wealth to a taxpayer's labor and the remaining portion to capital, the choice was made to treat all of the increase as capital gain in some cases and as ordinary income in others. A taxpayer's exertion of labor in managing his investment protfolio can result in an increase in wealth through the appreciation of the investments. While the increase is a product of a combination of capital and labor, the entire amount is treated as capital gain. It is common for there to be a division in partnerships where some partners contribute services, some contribute capital, and some may contribute both. Under partnership tax law, any income of the partnership is characterized at the partnership level and then allocated among the partners. The income allocated to a partner is not characterized by the nature of his contribution, but rather by the the charater the income had to the partnership as an entity. The situation in the case of partnerships with carried interest is not unique; to the contrary, it is fairly typical. There is no principled justification for differentiating the carried interest cases from other partnerships.

Posted by: Douglas Kahn | Jun 28, 2013 5:47:04 PM