How to Tax Carried Interest

By Kevin A. Hassett and Alan D. Viard Tuesday, June 1, 2010

Filed under: Economic Policy, Boardroom, Government & Politics

On May 28, the House of Representatives passed a bill that would make a number of significant tax and spending changes. The Senate is expected to vote on the bill shortly. One provision of the bill would increase the tax rate on the carried interest received by managers of equity funds, hedge funds, and others. In this article, we examine the billâ??s tax increase on carried interest.1

Background

We focus our background discussion on private equity funds, one of the key sectors that uses the carried-interest compensation arrangement. A private equity fund is a partnership. The fundâ??s limited partners are investors, usually a mix of wealthy individuals, corporations, and taxâ??exempt organizations. The fundâ??s general partner is the sponsoring private equity firm. The firm is itself a partnership, in which the managers are general partners. The fund, which may last for ten or more years, owns stakes in a number of portfolio companies at any given time. The stake in each portfolio company may be held for several years and then liquidated. Private equity funds include both buyout funds that purchase established companies and venture capital funds that finance startâ??up companies.

The private equity fund receives the income from holding and selling the portfolio companies. Because the fund is a partnership, the income is allocated among its partners. A common arrangement calls for the sponsoring private equity firm, as the fundâ??s general partner, to receive an annual fixed fee equal to 2 percent of the fundâ??s invested capital and a â??carried interestâ? equal to 20 percent of the fundâ??s income. As the firmâ??s general partners, the managers receive the fee and the carried interest.2

Part of the fundâ??s income, and therefore of the managersâ?? carried interest, may consist of ordinary income taxed at a 39.6 percent top rate. In most cases, however, a large portion of the fundâ??s income, and of the carried interest, consists of long-term capital gains and dividends taxed at a 20 percent tax rate.3

Proposals for Change

In early 2007, a then-unpublished article by law professor Victor Fleischer aroused congressional interest in the issue of whether carried interest, including the portion that consists of dividends and capital gains, should be taxed as ordinary income.4 In November 2007, June 2008, and December 2009, the House of Representatives passed bills that included provisions to tax carried interest as ordinary income, but these provisions were not passed by the Senate.5

On May 28, the House passed a revised version of the December 2009 bill. Unlike the three previous bills, the revised bill, which would take effect on January 1, 2011, would not apply the full 39.6 percent rate to capital gains and dividends received as carried interest. Under the bill, half of such income would be taxed at 39.6 percent and half at 20 percent in 2011 and 2012; thereafter, three-quarters would be taxed at 39.6 percent and one-quarter at 20 percent. The same tax treatment would apply to capital gains that the managers receive from sales of their partnership interests. The bill recognizes that some managers also invest their own money into the fund and (with an exception noted below) would preserve the 20 percent tax rate for capital gains and dividends allocated to those investments and for capital gains from the sale of such investments.

Proponents of this change make a simple argument. They contend that the 20 percent tax rate should apply only to capital gains and dividends that arise from the investment of the taxpayerâ??s own money, not to capital gains and dividends that the taxpayer receives as compensation for working. Because carried interest is compensation for the managersâ?? labor, the argument holds, it should be taxed at the same rate as wages; it is unfair that managers pay a lower tax rate on this labor income than their secretaries pay on wages. This rationale explains why the bill would generally allow the 20 percent tax rate when a manager invests her own money in the fund, but would disallow it when she is compensated for her labor.

Although this argument seems plausible at first glance, much of its plausibility disappears upon further scrutiny. To understand the issues, it is necessary to first dispose of several myths that have figured prominently in the debate.

DISSECTING THE MYTHS

Myth 1: Private Equity Funds Do Not Produce Real Output

It is now well-documented that private equity contributes significant value to firms and the economy.6 The empirical research shows increased profits, value, and cash flows. The private equity firm typically identifies a company that is underperforming and buys a stake in the company. This transaction generally involves the purchase of convertible securities bought at a discount, as well as board representation for the private equity firm. The firm brings to the table industry and financial modeling and assistance in recruiting, capital allocation, and management well beyond what a typical board member can offer. With these increased resources and expertise, firms can develop more effective goals, strategy, and leverage.

The ability to revive or create a successful business could well be a highly specific skill that would allow the most talented managers to earn very high returns. If such a star system exists, then the private equity organizational form might well maximize the social benefit contributed by the most talented managers. This is because the private equity model allows managers to swoop in, increase the value of an asset, then swoop out. Given the high returns achieved by the industry, there clearly is a valuable place in the American economy for such actors.

Myth 2: All Carried Interest Is Taxed at the Capital Gains Rate

In actuality, the tax treatment of carried interest is the same as the tax treatment that the partner would receive if she had received the income directly as an individual. If the fund sells a portfolio company that it has held for more than a year, the resulting profit is long-term capital gain. The partner pays the 20 percent rate on her share of that profit, just as she would if she had sold the portfolio company as an individual. If the fund receives interest income, however, the partner pays the 39.6 percent tax rate on her share of that income, just as she would if she had received interest income as an individual. (The 39.6 percent rate also applies to the fixed fees received by the managers.) The fraction of carried interest on which the partner receives the 20 percent rate therefore depends on how much of the fundâ??s income takes the form of capital gains and dividends.

Myth 3: Private Equity Funds Receive a Special Tax Break

The tax treatment of carried interest actually follows from partnership tax principles that apply to industries throughout the economy. Internal Revenue Code section 702(b) sets forth the general rule that partners are taxed on partnership income in the same manner â??as if such item were realized directly from the source from which realized by the partnership.â? If a furniture store partnership, for example, realizes long-term capital gains or dividends, the partners who gain are taxed at the 20 percent rate.

Some critics are troubled by the fact that the carried interest arrangement allocates part of the fundâ??s capital gains and dividends to the managers when such income â??belongsâ? to the investors who put up the money. Itâ??s not clear, of course, why the gains and dividends donâ??t belong to the managers, whose labor helped produce this income. In any case, Code section 704(a), a rule that also applies throughout the economy, permits the partnership agreement to allocate different items of partnership income and expense in any desired manner.7 If the furniture store partnership has two partners, one of whom works and the other of whom put up the money, the partnership agreement may allocate any capital gains and dividends received by the store to the working partner and she is then taxed at the 20 percent rate on that income.

The provision in the House bill would not alter the general rule that partners are taxed on partnership income at the same rate as if they had earned the same income directly. Instead, it would carve out an exception to that rule, partially applying the 39.6 percent rate to capital gains and dividends, for only some partners. The affected partners would be those who, at the time they acquired their partnership interest, are reasonably expected to perform â??a substantial quantityâ? of any of the following â??investment servicesâ?: advising about the value of securities, real estate (held for rental or investment), commodities, partnership interests, and related options and derivatives; advising about the desirability of holding such assets; managing, acquiring, or disposing of such assets; arranging financing to acquire such assets; or activities that support the above services. The provision is clearly intended to target managers at hedge funds, private equity funds, and real estate firms, although it could also affect some other partners. The general partnership rule would continue to apply to all other partners.

Myth 4: The Use of Carried Interest Turns Ordinary Income into Capital Gains

In some ways, this myth goes to the heart of the debate, because it concerns exactly how the tax savings from the use of carried interest arises. The best way to pose the question is: What are the tax implications of the fact that the fund pays carried interest to its managers rather than a salary?8

Consider a fund with one manager, one investor, and $100 of income, all of which is long-term capital gain. Also, assume that the fund simply gives the manager a 20 percent carried interest, ignoring fixed fees and other complicating features of actual compensation arrangements. So, the manager receives $20 of the capital gain and the investor receives the other $80.

Looking at the manager alone, carried interest does appear to turn ordinary income into capital gain. With carried interest, the manager is taxed at 20 percent on $20 of capital gain; if a salary had been paid instead, she would be taxed at 39.6 percent on $20 of wages. (The manager has a $3.92 tax savings). From an overall perspective, though, there cannot be any conversion between ordinary income and capital gain. The fund has $100 of capital gain, neither more nor less, and the only question is how to allocate it between the manager and the investor. So, to get the full picture, we also need to look at the investor. With carried interest, the investor has $80 of capital gain and no ordinary income. If the manager had received a salary instead, the investor would have received the entire $100 of capital gain and would have negative $20 of ordinary income (because the payment of the salary would be an ordinary business expense), which presumably could be used to offset other income.

Although the use of carried interest increases the managerâ??s capital gain by $20 and reduces her ordinary income by $20, relative to the salary alternative, the arrangement has the opposite effect on the investor. The use of carried interest rather than salary does not convert ordinary income into capital gains and dividends at the aggregate level, but instead reallocates the two types of income between the manager and the investor.

Carried interest is not guaranteed to yield a net tax saving in every instance. If the investor and the manager are both individuals in the top tax bracket, the $3.92 tax savings for the manager are offset by a $3.92 tax increase on the investor. There is no loss to the federal treasury. And, since both the manager and the investor know about the tax effects going in, they can negotiate the terms of their arrangement to cancel out their individual tax effects.

In practice, though, carried interest usually yields a net tax reduction, because the investor is often a tax-exempt organization that pays no tax on either capital gain or ordinary income. In that case, the reallocation of the two types of income is tax-reducing, because there is no offset for the managerâ??s tax savings. It is unsurprising that the Joint Tax Committee estimates an $18 billion revenue increase from the proposal.

Although carried interest often reduces taxes, the tax reduction is not obtained by â??turningâ? ordinary income into capital gain. Instead, it is obtained by reallocating the two types of income between managers and investors. The key question is whether this reallocation is inappropriate.

As stated above, this type of rearrangement is available to any partnership in the economy under general tax rules. To be sure, there are three reasons the tax savings available to private equity funds are likely to be greater than the tax savings available to other partnerships, such as furniture stores. First, the dollar amounts are larger. Second, capital gains play a much larger role for private equity funds than other partnerships; in a furniture store partnership, most of the income is likely to be ordinary operating income. Third, tax-exempt organizations provide more of the investment in private equity funds.

Before directly tackling the question of whether the tax saving from carried interest is appropriate, one more myth should be addressed.

Myth 5: Carried Interest Is Simply a Means of Tax Avoidance

In reality, carried interest serves important non-tax purposes by giving managers strong incentives to choose the best investments and manage them properly, and helping the firm attract more able managers (who would find this arrangement the most attractive). Fleischer, the most prominent advocate of changing the tax treatment of carried interest, has recognized that carried interest â??provides the most powerful incentive to work hard â?¦ and is considered essential to attracting talented managers.â?9 Carried interest would, therefore, likely be used even if it offered no tax savings; indeed, as the University of Chicagoâ??s David Weisbach has observed, it was used in years when capital gains and ordinary income were taxed at the same rates.10

Of course, because carried interest does usually provide tax savings, tax motivations have probably prompted its increased use to some extent. It also may have attracted more tax-exempt organizations to invest in funds that use this arrangement; if the provision is adopted, the incentive for tax-exempts to take their cash elsewhere may be powerful.

ARE THE TAX SAVINGS LEGITIMATE OR ABUSIVE?

With the myths disposed of, it is possible to address the question of whether the tax savings from the use of carried interest are improper. Should managers and investors be prevented from reallocating the two types of income in this manner?

Itâ??s important to realize that the tax savings from the use of carried interest are not markedly different from the tax savings that result from a variety of behavioral responses to the capital gains and dividend tax break. The key fact is that individuals enjoy a tax saving when they receive capital gains and dividends rather than ordinary income while tax-exempt organizations do not. That difference in treatment has ramifications for asset holdings throughout the economy. Compared to a world without taxes, individuals undoubtedly hold more assets that yield capital gains and dividends (such as stocks) and tax-exempts undoubtedly hold more assets that yield ordinary income (such as bonds). That rearrangement of asset holdings increases the tax savings generated by the capital gains and dividend tax break.

Like most tax-motivated asset reallocation, this reallocation is, by itself, likely to be inefficient. Itâ??s an inevitable consequence, though, of Congress deciding to offer a tax break for capital gains and dividends that is beneficial to some, but not all, asset holders. And, given Congressâ??s chosen form of the tax break, such reallocation actually makes the tax break more effective in stimulating new production that will yield capital gains and dividends. On balance, itâ??s far from clear that such reallocation should be aggressively discouraged.

To see how similar carried interest is to other asset reallocations, return to the earlier example. Supporters of the bill contend that it is improper for the fund to use carried interest to swap the $20 of capital gain between the manager and the investor. Suppose, though, that instead of using carried interest, the manager simply sold bonds that yielded $20 of ordinary interest income taxed at 39.6 percent and bought stocks that yielded $20 of capital gains taxed at 20 percent, while the tax-exempt investor sold stocks and bought bonds. Nobody would consider this portfolio reallocation improper. Is there any reason to condemn the carried interest arrangement that yields the same result?

One potential reason: Congress has imposed a limit on portfolio reallocation that doesnâ??t apply to the use of carried interest. The managerâ??s tax savings from portfolio reallocation are likely to hit a maximum at the point at which she puts her entire financial wealth in stocks and reduces her bond holdings to zero. She then has no more latitude to reduce interest income and increase capital gains. Of course, she could borrow and use the borrowed money to buy still more stock. But that strategy generally wouldnâ??t yield any tax savings because she couldnâ??t deduct the interest payments on her borrowing. Internal Revenue Code section 163(d) limits deductible investment interest expense to the amount of investment income taxed at ordinary rates, thereby preventing interest from being deducted against capital gains and dividends taxed at the 20 percent rate.

So, carried interest does permit some tax savings beyond what could be achieved through simple portfolio reallocation. The use of carried interest allows the manager and investor to achieve a larger exchange of ordinary income and capital gains than could be accomplished by the manager placing her entire financial wealth in stocks.

Is this extra latitude objectionable? The grounds for objection seem weak. The reallocation is achieved through the use of longstanding partnership tax rules that currently apply throughout the economy and that the bill would leave in place for most of the economy. Also, the managers to whom the gains and dividends are allocated helped generate the gains and dividends. Moreover, the use of carried interest is not primarily driven by tax motivations, but is instead motivated by the need to attract skilled managers and provide them with proper incentives. It is unclear why this method of reallocating ordinary income and capital gains income should be singled out.

In any case, one feature of the provision is particularly indefensible. As mentioned above, the provision would generally allow the 15 percent rate to apply to capital gains and dividends distributed to the managers when they invest money into the fund. But the provision sets forth one exception to that rule. Managers would remain subject to the higher rate imposed by the bill if they invested money they borrowed from the investors in the fund. Because managers who borrow from the investors would still be limited by section 163(d), it is hard to see why they should be targeted for an additional restriction not imposed on other people who borrow to buy assets that yield capital gains and dividends. As Fleischer himself has noted, there is â??nothing offensiveâ? about managers borrowing from investors.11 They receive no special tax break beyond what any other borrower would receive.

OTHER ISSUES

A number of other issues also raise concerns about the proposal.

Current Law Imposes Extra Tax Burden on Some Fund Managers

In some cases, the corporate income tax imposes a disguised payroll tax on fund managersâ?? earnings, a payroll tax that does not apply to other workers in the economy. The tax savings from the use of carried interest help offset this disguised tax.

The corporate income tax is normally a tax on capital rather than labor, because the corporation deducts its wage payments. This deduction cancels out the tax on the value that the corporation reaps from the employeesâ?? work. Consider the case, though, in which the corporation is a portfolio company held by a private equity fund and the fund managerâ??s work increases the corporationâ??s earnings. The corporate income tax paid on those extra profits reduces the after-tax value of the managerâ??s work and therefore reduces what the fund will pay her. But the corporation cannot deduct the compensation paid to the manager, because the manager is paid by the fund (the corporationâ??s stockholder) rather than the corporation. The result is a disguised payroll tax on the manager.12

Of course, there are a number of circumstances in which there is no disguised payroll tax. The portfolio company may not pay corporate income tax, either because it is a non-corporate firm or it is losing money. Or the managersâ?? labor may consist of buying and selling companies to exploit price discrepancies in securities markets rather than boosting the companiesâ?? operating profits. Or the managersâ?? labor may consist of devising better ways for the portfolio company to avoid corporate income tax, perhaps by adding to the companyâ??s debt. When the disguised payroll tax does exist, though, the tax savings from the use of carried interest plays the useful role of helping offset it.

Transition and Expectations