Carried Interest

There have been periods of debate and deliberation surrounding carried interest since the concept first emerged in 2007. The Inflation Reduction Act (IRA) of 2022 (Public Law 117-169) marks the most recent chapter of possible revisions, with early versions of the bill including a provision impacting the carried interest rules. Although the IRA ultimately didn’t change the taxation of carried interest, there remains a high level of commitment to increasing taxes on carried interest.

Key senators such as Sen. Kyrsten Sinema (I.-Ariz.) and Mark Warner (D.-Va.) have agreed to work together on future revisions of the current rules (Andrew Duehren, “Sen. Kyrsten Sinema Wins Tax Changes to Democrats’ Climate Bill,” The Wall Street Journal, August 4, 2022). With the possibility of change still in the air, it’s a prime time to review what carried interest is, how it’s currently taxed, and the policy viewpoints on the taxation of carried interest.

WHAT IS CARRIED INTEREST?

Private equity, venture capital, and hedge fund investments are commonly organized as limited partnerships. These investments are significant because (1) they have an estimated net asset value of roughly $14 trillion and (2) they foster the development of innovative businesses. Limited partners contribute the bulk of investment capital to the partnership and don’t actively participate in management. Their objective is to profit from appreciation in the partnership’s investments.

General partners actively manage the business interests of the partnership. They’re compensated annually via management fees, usually 2% of assets. They also earn a percentage of the appreciation in the value of the partnership’s investments, which is often 20%, if the appreciation exceeds an agreed-upon rate of return. This payment is called carried interest.

Although general partners frequently contribute a portion of the partnership’s investment capital, much of the appreciation in their portion of the investment (i.e., carried interest) is typically derived from “sweat equity,” or management services. 

Consider an example. Hedge Fund A sells its investments annually. It’s organized as a limited partnership. The limited partners contribute $100 million to the partnership. The general partners are entitled to 20% of the appreciation in the investment returns over 8% and a 2% annual management fee. At the end of Year 1, the investment has earned a 25% return, or $25 million. The general partners earn a 2% management fee, or $2 million ($100 million 5 0.02), and carried interest of $3.4 million ($100 million 5 (0.25 ‒ 0.08) 5 0.20). The limited partners earn $21.6 million ($25 million ‒ $3.4 million).

TAXING CARRIED INTEREST

Carried interest is currently taxed under Internal Revenue Code §1061, established under the Tax Cuts and Jobs Act of 2017. Carried interest held more than three years is taxed as a long-term capital gain, whereas carried interest held for three years or less is taxed as a short-term capital gain. The maximum long-term capital gains tax rate is 20%; short-term capital gains income is taxed as ordinary income at a maximum rate of 37%. A 3.8% Medicare surtax will also likely apply.

For example, Hedge Fund A held its carried interest for one year so that its general partners will pay taxes of $1,387,200 ($3.4 million 5 0.408). Private Equity Fund X earns the same carried interest, but the holding period is three years and a day. The tax due will be $809,200 ($3.4 million 5 0.238), a 42% decrease relative to Hedge Fund A. (Any management fees will be taxed as ordinary income in both cases.)

POLICY VIEWPOINTS

Most policy viewpoints on how carried interest should be taxed hinge on the character of carried interest income: Is it truly capital income; is it ordinary income, or is it a combination of the two? Supporters of the current approach of taxing carried interest often view general partners as having made an investment in the limited partnership and thus being entitled to capital gains treatment on the liquidation of their interests, much like the sale of stock.

Many opponents of this viewpoint suggest that carried interest compensates the general partners for managing the partnership, and, thus, the liquidation of their interests should be taxed at ordinary income tax rates, like wage income.

Others see carried interest as hybrid income. From this perspective, general partners have both a capital interest and a service interest in the investment partnership. The capital interest arises from the general partner’s monetary contributions to the partnership (if any). It should be taxed as capital income. The service interest arises from the services the general partner contributes to the partnership. Under traditional tax theory, the service interest should be taxed as ordinary income.

Other policy positions for modifying the current approach to the taxation of carried interest include:

• The current provision is rarely applicable to most private equity firms because the holding periods for most private equity investments exceed three years (Joseph Ferrone, “The Taxation of Carried Interest and Its Effects upon Cities,” Fordham Urban Law Journal, April 2020, pp. 717-745), so that the three-year holding period requirement has few meaningful consequences.
• General partners commonly earn high incomes. Some say it isn’t fair to give these partners a tax break on carried interest when average individual taxpayers can’t earn this tax break on their own compensation. 

Common policy positions for continuing the current tax treatment include:

• Investment partnerships shepherd the foundation of new companies that bring important innovations to the marketplace, greatly benefiting the U.S. government and U.S. consumers. A tax concession could be more than worth the value of these innovations to the U.S. economy.
• The Congressional Budget Office has estimated that additional tax revenues generated from taxing carried interest as ordinary income would be $14 billion across 10 years. Some argue that this amount of savings isn’t significant compared to the U.S. national debt of more than $31 trillion.  

Carried interest is likely to continue to be a prominent topic in taxation. Consequently, it’s important for financial professionals to understand the taxation of carried interest and the policy issues surrounding it. Ideally, these professionals will be prepared to react nimbly and counsel others in the advent of new legislation in this area.

© 2023 A.P. Curatola