Tax Carried Interest as Ordinary Income

Investment funds--such as private equity, real estate, and hedge funds--are typically organized as partnerships with one or more general partners managing the fund. The general partners determine investment strategy; solicit capital contributions; acquire, manage, and sell assets; arrange loans; and provide administrative support for all of those activities. Such partnerships also typically include limited partners, who contribute capital to the partnership but do not participate in the fund's management. General partners can invest their own financial capital in the partnership, but such investments usually represent a small share of the total funds invested.

General partners typically receive two types of compensation for managing a fund: a fee tied to some percentage of the fund's assets under management; and a profit share, or "carried interest," tied to some percentage of the profits generated by the fund. A common compensation agreement gives general partners a 2 percent fee and 20 percent in carried interest. The fee, less the fund's expenses, is taxed as ordinary income (and thus is subject to regular income tax rates). In contrast, the carried interest that general partners receive is taxed in the same way as the investment income passed through to the limited partners. For example, if that investment income consists solely of capital gains, the carried interest is taxed only when those gains are realized and at the lower capital gains rate. Until 2013, the general partners' share of dividends is also taxed at the lower rate.

This option would treat the carried interest that partners receive for performing investment management services as ordinary income. Income those partners received as a return on their own capital contribution would not be affected. The change would produce $10 billion in revenues from 2012 through 2016 and $21 billion from 2012 through 2021.

Arguments in favor of this option reflect the view that carried interest should be considered performance-based compensation for management services rather than a return on the financial capital invested by the general partner. In accordance with that viewpoint, the option would eliminate two notable differences in the way carried interest and comparable forms of income are currently taxed. First, taxing carried interest as ordinary income would make its treatment consistent with that applied to many other forms of performance-based compensation, such as bonuses and most stock options. Second, the option would equalize the tax treatment of income that partners receive for performing investment management services and the treatment of income earned by corporate executives who do similar work. (The managers of publicly traded mutual funds, for example, also invest in a variety of assets. And the executives of many corporations direct investment, arrange financing, purchase other companies, or spin off components of their enterprises.)

Arguments against the option reflect the view that at least a portion of carried interest represents a return on the financial capital invested by the general partner. From that perspective, carried interest is the equivalent of an interest-free nonrecourse loan from the limited partners to the general partner. That loan is equal to the agreed- upon share of the partnership's assets (commonly 20 percent), with the requirement that the loan proceeds be reinvested in the fund. (A borrower is not personally liable for a nonrecourse loan beyond the pledged collateral, which in this case would be the general partner's claim on future profits.) When the partnership sells its assets, it is argued, any gain realized or loss incurred by the general partner on his or her share (after the loan was paid back) could be legitimately viewed as a capital gain or loss.

Furthermore, this option would treat the income of partners who provide investment management services differently from that earned by entrepreneurs who start a new business, contribute both labor services and capital, and then sell the business. Profits from such sales generally are taxed as capital gains, even though some of those profits represent a direct return on specific labor services provided by the owners.

Another argument against such a policy change is that, if at least a portion of carried interest is presumed to be a return on the general partner's investment, it would reduce the incentive for general partners to undertake risky investments that can lead to innovation, new products, and more-efficient markets and businesses. It is not clear, however, to what extent a lower rate on capital gains contributes to such outcomes, or even whether promoting risky investment offers more economic advantages than disadvantages.

An alternative option, which presupposes that carried interest is neither entirely a return on capital nor entirely labor compensation, would explicitly recognize carried interest as an interest-free nonrecourse loan from the limited partners to the general partner. Under current tax rules, the implicit interest on that (nominally interest- free) loan would be determined by the interest rate on federal securities with the same duration and would be taxed as ordinary income. At the time the partnership sold its assets, any gains realized or losses incurred by the general partner (after the loan was repaid) would be treated as a capital gain or loss. The general partner would typically pay more in taxes than is assessed under current law but less than would be assessed if all carried interest was treated as ordinary income.

An advantage of the alternative option is that it would apply full taxation to at least some performance-based compensation without changing the underlying economics of the partnership arrangement. However, the approach is complex, which could make it particularly difficult to implement.