Monday, December 29, 2008
Recently, a significant debate over the taxation of so-called "carried interest" in private equity funds has received much attention from scholars, the government, commentators and the media. This debate has focused on whether private equity fund managers who earn a percentage of the returns generated by the fund should be entitled to capital gain treatment on such returns. The primary concern in this debate revolves around whether managers are effectively being compensated for services while receiving the benefit of long-term capital gains preferential rates. Proponents of reform point to the services being performed by the managers, while proponents of the current system point to the investment exposure to the underlying assets of the fund. A problem with the framework of this debate, however, is that both sides are partially correct; carried interest is "blended" in that it represents, in part, both a return to services and a return on capital. Since carried interest is blended in this manner, an analogy to either proves less than satisfying.
The issue of blended labor/investment returns is not new to the tax laws, however. Historically, the law has attempted to address the issue not by deconstructing such returns into constituent parts, but instead by imposing a "holding period" requirement. Under this approach, not all investments are created equal; rather, only capital investments held for an arbitrary period of time while bearing the risk of loss qualify for preferential rates. The current debate over the taxation of carried interest in private equity has failed to incorporate this crucial element into the analysis, i.e., the role that holding period plays in denying preferential rates to blended labor/investment returns, such as carried interest. This Essay will do so, concluding that, to the extent any reform of the taxation of carried interest is appropriate, a better approach may be through the application of the holding period rules rather than through current proposals to either change the definition of capital gains or further complicate the partnership tax rules.