Tax Carried Interest as Ordinary Income
The president’s budget proposes to tax the income from “carried interest” as ordinary income rather than as capital gains as under current law. Ordinary income is subject to marginal rates up to 35 percent (39.6 percent after 2012) while income from capital gains is taxed at rates up to 15 percent (20 percent after 2012).
Carried interest accrues to certain investment fund managers, including managers of hedge funds and venture capital partnerships. These managers generally receive part of their compensation in the form of an interest in the partnership, which entitles them to a share of partnership profits. If the partnership earns a capital gain, the manager reports his share—the carried interest—as capital gain income. The proposal would treat the manager’s share as ordinary income on the grounds that, for the manager, this partnership income represents compensation for services, not a return on investment.
Opponents of the provision argue the manager as a partner is entitled to capital gain treatment under the general rules for taxing partnerships in which the characteristics of a partnership’s income (either ordinary income or capital gains) flow through to partners. The difference, however, is that the manager has not purchased his partnership share, but has instead received this interest as a form of compensation for services. No income tax is paid by the manager on the value of the interest when it is received. The carried interest therefore represents a form of deferred compensation rather than a share in the partnership’s capital gains income.
The treatment most consistent with similar transactions would tax the estimated value of the partnership interest when received as ordinary income and subsequent profits as capital gains. This approach would treat the manager in the same manner as others who are compensated with shares or other investment interests. However, the value of a carried interest at the time it is received would be difficult in practice to estimate accurately.
Under the president’s budget proposal, a partner’s share of income from an “investment services partnership interest” (ISPI) would be taxed as ordinary income, regardless of the character of the income at the partnership level. Partners would be required to pay self-employment taxes on income from an ISPI. If a partner sells an ISPI, the gain would be taxed as ordinary income, not as a capital gain. The administration estimates that the provision would raise $14.8 billion through 2021.
Income that a partner earns from capital invested in the partnership would not be recharacterized provided that the partnership reasonably allocates income across invested capital and carried interests.
Tax Policy Briefing Book: Business Taxation: What is carried interest and how should it be taxed?
Tax Policy Briefing Book: Business Taxation: What are the options for reforming the taxation of carried interest?
Two and Twenty: Taxing Partnership Profits in Private Equity Funds, Victor Fleischer, New York University Law Review, 2008.
Taxing Partnership Profits as Compensation Income, Michael L. Schler, Tax Notes, May 28, 2008.