Carried Interest

By | Updated Nov 9, 2016 10:53 PM UTC

As widely reviled tax breaks go, few can match the one known as carried interest. It lets some high-earning managers in private equity or venture capital funds pay a lower tax rate on their income than most working Americans. Carried interest hinges on the idea that a partner in a long-term investment whose contribution isn't money but management skill should be regarded as a fellow entrepreneur. It’s a notion that dates back to the way Renaissance merchants paid ship captains for profitable journeys. To its critics, it's become a symbol of how the tax system can exacerbate income inequality.  

The Situation

During the U.S. presidential campaign, Donald Trump singled out the carried-interest exemption as a loophole to close in what was otherwise a determinedly business-friendly tax plan. The law as written lets rich managers “get away with murder,” the Republican said. It was one of the few points on which he and the Democrat he defeated, Hillary Clinton, agreed. In the U.S., the carried-interest benefit applies to partnerships that make long-term investments by buying or funding companies. It allows the profits going to managers in those partnerships to be taxed at the long-term capital gains rate of 20 percent, versus a top rate on ordinary income of 39.6 percent. (A 3.8 percent surcharge tied to Obamacare is added to both rates.) When President Barack Obama tried, unsuccessfully, to end the preferential tax treatment, the Treasury estimated that doing away with it would raise $17.7 billion over a decade, although a prominent critic of carried interest puts the figure at $180 billion. Britain in April began taxing carried interest at a higher individual rate of 40 percent for private equity funds that hold their investments for fewer than 40 months. Germany requires managers to pay ordinary rates of up to 47.5 percent on 60 percent of their carried-interest profits, with the rest tax free. Hong Kong doesn’t tax capital gains, but authorities are considering taxing some portion of partnership profits now considered carried interest.

The Background

In the 1600s, Venetian merchants would send ships to carry porcelain, grains and silk in rat-infested holds across stormy seas. A captain's compensation was an “interest” in the value of the cargo, making him a partner in the venture. Private equity funds buy stakes in companies they see as undervalued and fix them up (or strip them of assets, depending on your point of view) before selling them, usually five to seven years later. Venture capital funds invest in startups and wait for them to grow. In addition to a salary, executives in either kind of fund who are designated as general partners receive what’s known as “2 and 20” — a fee of 2 percent of assets under management and 20 percent of profits that are carried over from year to year until a company is sold. In 1954, Congress approved rules making money distributed by partnerships non-taxable. The idea was that income from partnerships, then a relative novelty, shouldn’t be taxed twice — at the corporate level and personally. The rules didn’t foresee that private equity and venture capital would explode in size, starting in the 1980s. The American Investment Council, private equity’s powerful lobby, says that in the second quarter of 2016, some 4,100 U.S. private equity firms had $146 billion invested in U.S. companies and took out $83 billion in profits. Hedge funds are often lumped in by critics of carried interest, but their focus on short-term trading strategies means they rely on other provisions to hold down their tax rates.

Source: 2016 Preqin Global Private Equity and Venture Capital Report

 

The Argument

Opponents argue that carried interest is simply remuneration for the work involved in growing a company a fund invests in. They say that the preferential long-term capital-gains treatment should be reserved for investors who are risking their own money. Supporters argue that carried interest is akin to “sweat equity.” They call fund managers entrepreneurs who take on the risk of raising money from outside investors and putting the dollars into companies that might not pan out. They say the tax incentive contributes to job growth and innovation.  

Reference Shelf

  • Tax lawyer Victor Fleischer wrote an influential 2008 research paper that called to end the tax benefit. He is now co-chief tax counsel for Senate Finance Committee Democrats.
  • The Tax Policy Center, a think tank under the Urban Institute and Brookings Institution, has a simple, balanced guide — call it "Carried Interest for Dummies."
  • The American Investment Council, the lobby formerly known as the Private Equity Growth Capital Council, defends the tax benefit as a driver of economic growth.
  • University of Chicago law professor David Weisbach took up the scholarly bat in a 2008 paper that defends the beneficial tax treatment
  • The Congressional Research Service, which serves Congress, describes the major tax issues around carried interest in a 2014 report.
  • Gregg Polsky, a University of Georgia tax law professor, wrote a widely-read exploration in 2014 that describes the use of carried interest as one of private equity's "tax games."

 

 

First published Aug. 8, 2016

To contact the writer of this QuickTake:
Lynnley Browning in New York at lbrowning4@bloomberg.net

To contact the editor responsible for this QuickTake:
John O'Neil at joneil18@bloomberg.net