NCPA - National Center for Policy Analysis

SHOULD CARRIED INTEREST BE TAXED AS ORDINARY INCOME?

July 1, 2010

Carried interest is a share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds.  This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund's performance. 

Congress is debating a bill that would tax carried interest at higher rates.  However, raising the tax rate on carried interest will not result in any net gain to the U.S. Department of the Treasury, but it will have negative impacts on productivity, wages and the cost of investment, says Stephen J. Entin, president and executive director of the Institute for Research on the Economics of Taxation. 

Consider a case in which the partnership earns capital gains and the general partner gets part of the total: 

  • The Treasury will collect an amount equal to the total capital gains income times the capital gains tax rate. (For instance, $1,000 multiplied by the 15 percent capital gains rate equals $150 in tax revenue.)
  • It will collect some from the limited partners and some from the general partners -- the split does not affect the total revenue ($150). 

Now consider an alternative to carried interest in which the partnership pays the general partner a management fee high enough to compensate for the higher tax rate on the general partner, and the limited partners keep and pay tax on the entire $1,000 capital gains: 

  • The general partner would pay ordinary income tax rates on their fee; for example, 35 percent on a fee of $100 equals $35.
  • But the limited partners would get a tax deduction for the management fee that they could claim against ordinary income.
  • The tax they save with the deduction of the management fee would equal the tax paid on the fee by the general partners ($35), resulting in zero net revenue to the Treasury. 

The Treasury would only receive the tax on the capital gains earned by the partnership.  In other words, if carried interest were treated as ordinary income, and replaced by fees, the Treasury would net no additional income, says Entin. 

Source: Stephen J. Entin, "Should Carried Interest Be Taxed as Ordinary Income?" National Center for Policy Analysis, Brief Analysis No. 712, July 1, 2010. 

For text:

http://www.ncpa.org/pub/ba712

 

Browse more articles on Tax and Spending Issues