Tax Carried Interest as Ordinary Income

Background

Investment funds—such as private equity, real estate, and hedge funds—are often organized as partnerships. Those partnerships typically have two types of partners: general partners and limited partners. General partners determine the partnership's investment strategy, seek contributions of capital and loans to acquire assets, manage those assets, and eventually sell them. Limited partners contribute capital to the partnership but do not participate in its management. General partners can invest their own capital in the partnership as well, but such investments usually represent a small share (between 1 percent and 5 percent) of the total capital invested.

General partners typically receive two types of compensation for managing a fund: a management fee tied to some percentage of the fund's assets and "carried interest" tied to some percentage of the fund's profits. For example, general partners may receive a management fee equal to 2 percent of the invested assets plus a 20 percent share of the profits as carried interest if returns from the fund exceed a threshold. The fee, less the fund's expenses, is subject to ordinary income tax and the self-employment tax. By contrast, carried interest associated with gains from the sale of an asset held for more than three years is usually taxed at the rate that applies to long-term capital gains, which is typically much lower than that for ordinary income, and that carried interest is also not subject to the self-employment tax.

Income from carried interest is not separately reported by taxpayers and is therefore not directly measured. Income from investment funds and from carried interest generally grows more rapidly than the economy during booms and more slowly than the economy during recessions. (Additional background information and data related to carried interest can be found in Joint Committee on Taxation 2007.)

Option

This option would treat carried interest that general partners receive for performing investment management services as labor income, taxable at ordinary income tax rates and subject to the self-employment tax. Income those partners receive as a return on their own capital contribution would not be affected.

Effects on the Budget

If implemented, the change would produce an estimated $14 billion in revenues from 2019 through 2028, according to the staff of the Joint Committee on Taxation. That estimate takes into account the anticipated responses of general partners, who would probably restructure their compensation to lower their taxes. For example, to make an investment requiring $100 million, the general partner could secure a $20 million interest-free nonrecourse loan (a loan secured by a pledge of collateral but for which the borrower is not personally liable) from the limited partners to invest in the fund, and the limited partners could separately invest $80 million directly in the fund. If the assets of the investment fund were sold for a profit after three or more years, the gains realized by the general partner on the $20 million loan would equal 20 percent of the fund's total gains. The general partner would then claim that income as a capital gain subject to the same lower tax rates as carried interest under current law. However, even if compensation agreements between limited partners and general partners were restructured in that manner, federal receipts would still rise, although by less than they would if restructuring was not feasible. That is because, under current law, the general partner is required to treat the forgone interest on the nonrecourse loan as income and pay tax on it at the higher ordinary rate. The revenue estimates shown above reflect the likelihood and the consequences of such restructuring.

The estimate for this option is uncertain because of uncertainty surrounding estimates of income from carried interest. The estimate also depends on the Congressional Budget Office's economic projections, which are inherently uncertain. General partners typically earn carried interest only when their fund generates a return in excess of a threshold, and their likelihood of earning that return depends on economic conditions. Additionally, there is uncertainty about the degree to which general partners would be able to employ strategies such as the use of nonrecourse loans to avoid recognizing carried interest as ordinary income.

Other Effects

An argument in favor of this option is that carried interest could be considered performance-based compensation for management services. By taxing carried interest as ordinary income, this option would make the treatment of carried interest consistent with that of many other forms of performance-based compensation, such as bonuses, royalties, and most stock options. In particular, the option would equalize the tax treatment of income that general partners received for performing investment management services and the income earned by corporate executives who do similar work. (For example, many corporate executives direct investment, arrange financing, purchase other companies, or spin off components of their enterprises, yet profits from those investment activities are not counted as individual capital gains for those executives and are therefore not taxed at preferential rates.)

An argument against this option is that a portion of the profits generated by the sale of an investment fund might be attributable to intangible assets, which are independent of the services provided by the general partner. By taxing the full carried interest—even the portion attributable to intangible assets—as labor income instead of capital gains, this option would treat general partners of investment funds differently from general partners in other industries. An alternative approach would be to allow a fraction of carried interest to continue to be treated as capital gains.

Another argument against the option is that, by reducing the expected after-tax compensation of general partners, it would reduce their incentive to start investment funds. That reduced incentive, in turn, could diminish innovation and possibly make private equity markets—and consequently businesses—less efficient. It is not clear, however, to what extent the current treatment of carried interest promotes innovation and market efficiency.