Carried interest, the share of profits that private equity fund managers receive, is currently taxed at the capital gains rate, but it should be treated as standard compensation.
In recent months, there has been a growing consensus that the tax code is broken and must be reformed or overhauled. Unfortunately, that’s where the consensus ends. Politicians are loath to eliminate provisions that garner them support, and the result is that the tax code is riddled with small loopholes that end up costing big bucks. One of the failures of the tax code is the unequal treatment of similar activities, such as the tax treatment of carried interest. Although only a few people even know what carried interest is, this provision costs the government around $1.3 billion annually. That’s a big break for just a few people. The fault lies not with the individuals who take advantage of these provisions, but rather with the legislators who enacted them and today, fail to eliminate them.
Taxation of carried interest has been around since the implementation of subchapter K of the Internal Revenue Code, which governs the taxation of partnerships, in 1954. Though part of the tax code for over half a century, the taxation of carried interest only became a hot-button subject recently, when private equity firms and hedge funds rose in prominence in the financial sector.
Private equity and hedge funds manage an estimated $1 trillion each, and private equity raised around $240 billion in capital in 2006. With such a large amount of assets under management, legislators and policymakers have taken a closer look at the taxation of their earnings.
Carried interest (or profits interest) arises as part of a partnership arrangement. When a private investment fund is formed, it usually comprises two types of partners. Limited Partners (LPs) contribute capital to the investment fund. General Partners contribute knowledge of investments, some capital (usually 1-5 percent of the firm’s assets) and manage the funds on a day-to-day basis. It is important to note that partnerships are pass-through entities, meaning profits are not taxed at the partnership level, but rather each partner is taxed individually.
General Partners are paid a management fee, usually around 2 percent of the fund’s assets, for the day-to-day operations they oversee. This management fee is taxed at the ordinary income tax rate. When the fund turns a profit, LPs usually receive 80 percent of the profits (called capital interest), and GPs receive around 20 percent of the profits, sometimes not until a profit threshold (say, 7 or 8 percent) is reached. The share of the profits that the GP receives is called carried (or profits) interest, and is currently taxed at the capital gains tax rate.
Most private equity funds have a lifespan of 5-7 years, so the income gained during this time is applicable for favorable long-term capital gains tax treatment, as opposed to hedge funds profits, which usually constitute short-term capital gains. Both long- and short-term capital gains rates are lower than traditional income rates.