Taxation of Carried Interest – The Debate Continues as Legislation Looms

I first wrote about proposed changes in the taxation of carried interests (the manager’s share of income from a venture or private equity fund) in June of 2008 (see http://archive.constantcontact.com/fs056/1101631528224/archive/1102150842963.html). Last December, the House finally approved a bill to tax carried interests at ordinary income rates rather than capital gains rates (and subject such profits to self-employment tax). While H.R. 4213 contains language to ensure that an investment fund manager’s pro rata allocations of capital gain attributable to invested capital will remain subject to the preferential capital gains rates, many individuals (mostly fund managers) believe it is neither fair nor economically advisable to tax any portion of the allocations to investment fund managers at ordinary income rates. If the legislation passes, the higher rates would take effect for taxable years ending after December 31, 2009, and the bill contains no exemption for existing carried interest arrangements.

So, should carried interest be taxed at ordinary rates? The argument for capital gains treatment relies on the fact that the income is earned at the fund level as capital gains, and thus when being split amongst its owners it should retain its fund-level classification as capital gains. General rules of partnership taxation dictate this result, and it may be unfair and discriminatory to treat an investment fund different from any other type of partnership arrangement. The argument for ordinary income treatment relies on the fact that compensation income is taxed at ordinary rates, and the investment fund manager’s receipt of profit allocations is really just a disguised payment of compensation income. Because the investment manager is not receiving its allocation of profits in proportion to its invested capital, it should not be entitled to treat its allocation of fund income as capital gain.

Tax professionals come out on both sides of this dispute. There are good arguments for both positions, and the matter will ultimately come down to a matter of policy, or persuasive lobbying.

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