Taxing Carried Interest

Brief Analyses | Taxes

No. 834
Monday, August 08, 2016
by John White

Over the past several years, there has been much debate about how to tax the compensation of the managers of private equity, venture capital and hedge funds. The issue is important because these funds provide capital for businesses at various stages of development or seek to minimize risks for investors, and raising taxes on these funds would reduce the rate of return to fund investors.

  • Private equity funds, which own interests in companies that are not publicly traded, managed an estimated $2 trillion in worldwide assets in 2013, according to TheCityUK, a financial services organization. Venture capital funds, a type of private equity fund which specialize in startup ventures, invested about $60 billion in 2015, according to the National Venture Capital Association.
  • Hedge funds, which pool capital from accredited investors and reduce the risk of losses by short selling against a long-term investment plan, managed an estimated $2.9 trillion in assets worldwide in 2015, according to the New York Times.

These funds are usually organized as partnerships and are managed by one or more of the partners. The general managing partners receive a flat fee (salary) from the other partners and/or an ownership interest which entitles them to a share of the profits upon sale of the fund’s assets, called “carried interest.” This portion of the fund manager’s compensation carries risk: They do not receive it unless the fund gains value, and even then, they may have to wait to receive it until assets are sold. Some hedge fund managers are very wealthy — the top 25 hedge fund managers earned $13 billion in compensation last year, according to the New York Times. However, many other hedge funds are much less successful or even fail, in which case the managers receive little or no carried interest.

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