What Is Carried Interest (and How Should It Be Taxed?)

Carried Interest and Preferential Tax Treatment

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Carried interest is income––but what kind of income? Therein lies the debate. Should it be taxed as capital gains or is it ordinary income?

The Internal Revenue Code treats each quite differently. Ordinary income is taxed according to tax brackets and it includes sources like wages, salaries, self-employment income, and even some unearned income such as interest. According to the Legal Information Institute, ordinary income also includes "any gain from the sale or exchange of property which is neither a capital asset nor property described in Section 1231(b)" of the Internal Revenue Code.

Capital gains, on the other hand, is "the difference between the basis and the amount the seller gets when they sell an asset. The basis is usually what the seller paid for the asset," according to the IRS. Long term capital gains tax rates are 0%, 15%, or 20% as of 2019, depending on overall income.

Some say that this distinction provides an unfair advantage to wealthier individuals who make money from managing private equity funding.

What Is a Private Equity Fund?

Private equity funds raise capital from investors and use that money to buy companies. These companies are often struggling. They badly need capital. A private equity fund buys the business and puts it on its feet again through revisions to operations or even to structure.

The fund makes the company profitable then it sells it again, either privately or through a public offering. Profits from the sale are passed on to the fund’s general and limited partners.

What's in a Name?

The “private” part of the term relates to who these equity fund investors are. Private equity funds do not accept or solicit capital from the general public or retail investors, but only from private investors.

Reporting requirements are less exacting so these funds can do what they do without revealing their target companies and their goals to competing investment funds and to the market, which could skew profits.

The Investment Company Act set the terms for investment companies back in 1940. These private funds qualify for special tax treatment under the 3C1 and 3C7 exemptions of the Act, both of which limit the number of qualified investors they may have.

In some cases, private equity funds are formed by families and they operate entirely on family wealth. Some hedge funds can be private equity funds, but the two terms are not synonymous. Hedge funds tend to focus on a wide variety of short-term investments whereas private equity funds invest in businesses with long-term goals in mind.

What Is Carried Interest?

Carried interest, sometimes simply called “carry,” is a share of the profit when a private equity fund sells a business—a share of the fund’s net capital gains on the purchased business. According to the Tax Policy Center:

"Carried interest is income flowing to the general partner of a private investment fund, often is treated as capital gains for the purposes of taxation. Some view this tax preference as an unfair, market-distorting loophole. Others argue that it is consistent with the tax treatment of other entrepreneurial income."

Carry makes up at least a portion of the compensation paid to a general partner of a private investment or private equity fund. It’s compensation for ensuring that the limited partners achieve a return on their own investments.

The general partner manages the fund’s investments. Carried interest is paid regardless of whether the general partner personally invested anything toward the purchase of the company that generated the profit.

About 80% of carried interest eventually trickles down to the fund’s limited partners, those who initially invested capital. The general partner receives the other 20%, as well as compensation in the form of an annual management fee—a percentage of the fund’s assets.

Carry only occurs when the sale of an acquisition results in profits that exceed a certain threshold that’s referred to as the hurdle rate. It doesn’t necessarily result from every venture or sale.

How Carried Interest Is Taxed

Carried interest has historically been taxed as capital gains, just like income that might be derived from other types of investments. After all, it represents capital gains to the private equity fund itself. It’s not treated as ordinary income and this generally means it’s taxed at a lesser rate.

Carry is typically subject to the 20% capital gains tax rate plus the 3.8% net investment income tax for a total of 23.8%. Contrast that with the highest tax bracket for ordinary income as of 2019—37% for single taxpayers with incomes over $510,300, plus that 3.8% investment tax again—and you can see what the hue and cry is all about. That’s a big tax break.

Pros and Cons

Opponents argue that carry should be taxed in the same way income is for regular wage-earners. What sets general partners and limited partners apart? Investment bankers pay ordinary income tax rates on their earnings so why shouldn’t these participants in private equity funds do so as well?

Proponents of the capital gains carry loophole take the position that were this income to be taxed at regular rates, it would deter investors from participating in these types of funds. This could potentially have a negative impact on the economy and could virtually cripple the concept of these funds.

Is the Loophole Closing?

Some changes came about when the Tax Cuts and Jobs Act went into effect in 2018. The TCJA requires that investment funds hold on to acquired businesses for at least three years to become eligible for the more favorable long-term capital gains tax rate. But the TCJA initially excluded all corporations from this rule.

As a result, many private equity funds scurried to reorganized themselves as S corporations. The Treasury and the Internal Revenue Service responded by announcing that this would not be permitted. The U.S. Treasury Department said in March 2018 that it would not allow private equity funds to operate as and file taxes as S corporations. S corps are not taxed at the corporate rate or level. Profits trickle down to their shareholders for taxation purposes.

Additionally, the TCJA rule is expected to apply the capital gains exemption only to C corporations. These corporations pay a corporate tax before paying dividends to shareholders. 

Article Sources

  1. Legal Information Institute. "26 U.S. Code 64. Ordinary Income Defined." Accessed Oct. 2, 2019.

  2. Internal Revenue Service. "Capital Gains and Losses—10 Helpful Facts to Know." Accessed Oct. 2, 2019.

  3. Tax Policy Center. "What Is Carried Interest, and Should It Be Taxed as Capital Gain?" Accessed Oct. 2, 2019.

  4. Tax Policy Center. "Effects of the Tax Cuts and Jobs Act: A Preliminary Analysis," Page 19. Accessed Oct. 2, 2019.