Carried Interest Debate

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Carried interest is a form of performance-based compensation that general partners of private investment funds receive in exchange for their work. It is generally calculated as 20 percent of a fund's profits[1]. The Carried Interest Debate revolves around the controversial tax policy imposed upon carried interest in the United States. Currently, carried interest is treated as a capital gain for tax purposes rather than ordinary income, which results in it being taxed at a maximum rate of 20 percent[2] rather than 39.6 percent[3] and receiving a perceived advantageous tax deferral. Opponents of carried interest criticize this tax policy for being unjust, calling it a "loophole" that allows the wealthy to avoid fair taxation. Its supporters argue that the policy is necessary to encourage investment activity.

Private Investment Fund Structure

Before considering carried interest, one must first have a basic understanding of the organizations that currently benefit from it. Private investment funds, set up as limited liability companies or limited partnerships, invest capital in order to attain returns for investors. These funds are organized under general partners and limited partners. The general partners are the funds' managers or managing firms. The limited partners are the funds' investors who typically include pension funds, insurance companies, and wealthy individuals. Types of private investment funds consist of private equity funds, venture capital funds, and hedge funds. In reality, the lines between these types of funds can often be blurred, but the key distinctions can be summarized as follows:

  • Private equity funds generally invest in large companies with the intent to restructure and sell the firms for a gain. These investments usually entail acquiring controlling interests in public companies through stock purchases, but they may also involve acquiring private companies. In the case of the public company, funds often take the company private before the resale or new initial public offering. The process by which private companies are brought to liquidity is similar sans the return from public to private. Private equity funds usually employ a long-term, hands-on approach to investment.
  • Venture Capital funds aim to invest in high-tech startups with high-growth potential in exchange for a stake in the company. Once the fund purchases a stake in the company, it also provides coaching and other services to the company in order to increase its chances of success. Similar to private equity funds, venture capital funds invest with a hands-on, long-term strategy with the eventual goal of a liquidity event, i.e. a(n) acquisition, merger, or initial public offering.
  • Hedge funds tend to focus on achieving high returns through risky investments that may come in the form of stocks, bonds, commodities, derivatives, and anything else that promises a strong gain. Accordingly, hedge funds tend not to adopt the same hands-on approach to investment that venture capital and private equity funds do.

Carried Interest

General partners are compensated for managing their private investment funds through management fees and carried interest. Management fees are consistently around 2 percent of a fund's assets under management and are paid regardless of the fund's performance. Carried interest, alternatively, serves to join the incentives of the general partners with the interests of the limited partners by providing performance-based compensation for the general partners. When a private equity or hedge fund surpasses its hurdle rate of return, which is usually about 8 percent, the general partners will typically receive around 20 percent of the profits as compensation[4]. The general partner in a venture capital fund, on the other hand, will consistently receive 20 percent of the profits as long as the limited partners have received a return at least equal to their contributed capital[5]. This 20 percent, in combination with any other profit the general partner may receive from their own stake in the fund, is treated as a capital gain for tax purposes. The 2 percent management fee is treated as ordinary income for tax purposes[4]. The maximum tax rate for a capital gains tax is 20 percent[2], compared to the maximum tax rate for an ordinary income tax of 39.6 percent[3].

The Debate

Carried interest is an ongoing issue for politicians, the public, and investors alike. Due to the ambiguity of the issue and substantial lobbying on the part of financial institutions, the opponents of carried interest have had little success with policymakers. Opensecrets.org reports that more than $1.1 billion[6] was donated to Democratic and Republican congressional campaigns by financial institutions in the years 2012 and 2014. However, presidential nominees Donald Trump and Hillary Clinton both spoke out in opposition of carried interest in the 2016 election, advocating taxing capital gains as ordinary income[7].

Those who argue against treating investment funds' profits as capital gains have two primary points:

  • The first of which is that carried interest is only taxed when it is realized. Through this tax deferral, the carried interest can benefit from the time value of money. Thus, the general partners at the private investment funds then have what some perceive to be unfair tax advantage. The limited partners, if they are taxable, are then at a comparative tax disadvantage because they cannot receive a deduction for the carried interest when it is granted. If they are not taxable, as many limited partners aren't (i.e. pension funds), then the government loses tax revenue. The tax deferral argument is particularly more relevant when it comes to funds that are not persistent in their performance. When a fund is consistent in its increasing returns, as venture capital funds tend to be, the deferred taxes grow greater over time. When a fund has inconsistent returns, the smaller deferred taxes from bad years offset the higher deferred taxes from successful years, generating a benefit for a lack of persistence in performance [4].
  • The second and more emphasized point is that carried interest is subject to the capital gains tax rate mentioned before. Opponents of such treatment consider carried interest to be a performance-based compensation, much like a bonus, and thus believe that carried interest should be taxed at the ordinary income rate. In their argument, the opponents frequently compare general partners' roles to those of corporate executives and mutual fund managers, two parties who are subject to the ordinary income rate[8].

Those in favor of the current treatment of carried interest argue that the general partner's role is more analogous to that of an entrepreneur. Just as an entrepreneur sells his or her business and is taxed at the capital gains rate, so too should the general manager be taxed on his or her realized gains at the capital gains rate. Further, it is claimed that a higher tax rate would reduce incentive for general partners to take risks. This lack of incentive would then discourage innovation and efficiency in markets. However, it is not clear whether there is evidence for these claims or if the risks general partners take on provide a benefit to the economy as a whole[8].

References

  1. [1] 'What is carried interest, and how should it be taxed?', Tax Policy Center,(Washington D.C.),
  2. 2.0 2.1 [2] K. Bell, 'A look at long-term capital gains tax rates', Bankrate.com, (New York City: April 2016)
  3. 3.0 3.1 [3] K.Pomerleau, '2016 Tax Brackets', Tax Foundation, (Washington D.C.: October 2015)
  4. 4.0 4.1 4.2 [4] V. Fleischer, 'Two and Twenty: Taxing Partnership Profits in Private Equity Funds',New York University Law Review, (New York City: April 2008)
  5. [5] R. Gilson, 'Engineering a Venture Capital Market: Lessons from the American Experience', Standford Law School, (Stanford: November 2002)
  6. [6] Center for Responsive Politics
  7. [7] M. Pearl, 'What the carried interest tax loophole reveals about our corrupt political system', The Hill, (Washington D.C.: October, 2015)
  8. 8.0 8.1 [8] 'Tax Carried Interest as Ordinary Income', Congressional Budget Office, (Washington D.C.: November 2013)

1The Taxation of Carried Interest: Understanding the Issues

2Hedge Fund Characteristics and Performance Persistence

3Has Persistence Persisted in Private Equity? Evidence From Buyout and Venture Capital Funds

4 Carried Interest: A Loophole in America’s Tax Code

5 The Taxation of Carried Interest

6 What is the difference between a hedge fund and a private equity fund?

7Taxation of Hedge Fund and Private Equity Managers]