Carried Interest: Labor vs. Capital

Daniel G. Mazzola, CPA, CFA
Published Date:
Apr 1, 2016

The U.S. government promotes business activity via the I.R.C. by taxing the profits of the sale of investment assets held for at least one year at a lower rate than the one at which income for services rendered is taxed. The lower capital gains rate is afforded to individuals acting alone or as part of a partnership. Capital is an important driver of economic growth; without this favorable treatment, investors would be less inclined to stake risky but essential ventures, such as those in the medical and technology industries.

Those unfamiliar with this concept would likely question the taxation of carried interest.  Carried interest is the compensation private equity fund managers receive if the return they generate for their clients exceeds a certain hurdle rate. It is taxed at the lower capital gains rate, regardless of whether or not the manager has contributed his own financial resources to the investment fund.  Critics of this treatment contend these private equity managers should pay higher ordinary income rates on carried interest, as it reflects return on labor and not capital. Much of the controversy stems from the fact that some private equity managers are already quite wealthy and - in the minds of those opposing the lower rate - neither need nor deserve another tax break. Our tax regime, however, is more efficient and equitable if income earned in a similar manner is also taxed in a similar manner.  We cannot have a system that discriminates against a class of people simply because they are engaged in a lucrative profession, or because their endeavors do not always produce a beneficial outcome for all involved.     

A private equity fund is typically structured as a partnership consisting of limited partners and a general partner. Limited partners provide capital, have no say in the daily operation of the fund, and cannot be sued for the debts of the partnership. A general partner, on the other hand, does the day-to-day work and may be sued for partnership liabilities. He is paid a flat fee, usually 2% of fund assets, which is taxed as ordinary income. The carried interest, or the percentage of profits received if the investment is successful, is normally 20%.  While general partners typically contribute 1-10% of the initial assets of the partnership, it is not a requirement. Thus, a general partner will receive a disproportionate share of the profits in relation to his financial commitment. 

Those that argue that capital gains treatment should not be allowed for carried interest are putting a higher value on financial capital than “sweat equity.” The success of the venture is often attributable to the general partner’s participation, as he is involved in strategy, business development, financial management, and restructuring and operational details. His responsibility is to return the company to profitability, restructure it to generate returns, and unlock hidden value - and he does not receive the carried interest unless he does so. U.S. tax law currently makes no distinction between the contributions of the limited and general partners when taxing profits on the sale of investment assets.    

The underlying principle of a private equity fund is similar to two friends who establish a partnership to develop real estate, restore a foundering business, or operate a lemonade stand.  One party may bring capital, while the other brings necessary expertise in identifying the property or suitable location, managing the enterprise so value is added over time, and selling at an appropriate price. Upon liquidation of the investment, both partners receive the lower capital gains rate on the profit, even though their contributions to the successful venture are different.  This equal treatment is a tenet of partnership law, and any attempts at tax reform that re-characterize carried interest as ordinary income could easily lead to unforeseen circumstances within an already complicated area of tax law.

When it comes to tax avoidance, some hedge fund managers are painted with the same populist brush as private equity managers; however, there are important differences between the two that result in different tax consequences. Unlike private equity managers, hedge fund managers rarely take a controlling interest in companies for which they invest, and few hedge funds hold a position for more than a year. Thus, the carried interest treatment is not generally applicable to the profits of hedge fund managers.

Proponents of the current practice contend that taxing carried interest at the capital gains rate is appropriate because there are usually conditions attached that make it a less reliable source of income than a regular salary. As noted previously, a manager’s carried interest is contingent on a specified rate of return. Furthermore, the life span of a private equity project is five to 10 years, and the carried interest only becomes available upon a liquidity event: an initial public offering, acquisition, or recapitalization of the enterprise.  Opponents assert that private equity firms take the form of partnership taxation to the extreme. The work of a private equity firm is essentially a combination of investment banking and management consulting. Managers are not paid for starting new ventures from scratch, but by pooling the money of wealthy people, institutions and pension plans, and speculating on the future of a business. In their minds, they do not serve a useful purpose and contribute little, if anything, to our nation’s general welfare.      

We now have an avowed socialist running for president of the United States, attracting the disillusioned with his philippics on economic inequality and the “1 percent.”  But where is it written in the Declaration of Independence, Constitution, or tax code that one individual has a legitimate claim on the wealth of another? Taxes are necessary, but a system that applies discriminatory taxation on income under the misleading name of progressive taxation is not a mode of taxation – rather, it is a disguised expropriation of successful capitalists, entrepreneurs, and the affluent. Our tax laws should not be used as a tool for implementing social change. A sound tax policy involves simple, transparent, low marginal, rarely altered tax rates, and a very broad base, with the rights of private equity managers just as inviolate as those of the poor and middle class. 

Daniel G. Mazzola, CPA, CFADaniel G. Mazzola, CPA, CFA, is an investment advisory representative with American Portfolios Advisors Inc. He is a Chartered Financial Analyst, Certified Public Accountant and Certified Financial Planner. Mr. Mazzola is a member of the NYSSCPA Personal Financial Planning Committee. 

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