September 2007

How Should Private Equity Fund Managers Be Taxed? The Carried-Interest Debate

Earlier this year, an article by Victor Fleischer, a professor now at the University of Illinois College of Law, helped turn a technical aspect of partnership taxation into the most contentious tax policy issue of 2007. Members of Congress, the George W. Bush administration, the 2008 presidential candidates, academic commentators, and the media have now joined the debate about what tax rate should be applied to “carried interest,” a major component of the compensation of private equity fund managers. Carried interest is the managers' share of the profits from the fund's investments. Under current law, managers are taxed on much of the carried interest at the 15 percent rate used for dividends and capital gains rather than at the top 35 percent rate used for ordinary income. Congress is now considering a proposal to tax the carried interest as ordinary income. Any such change could also impact other industries, including real estate and oil and gas.
 
Supporters of the pending proposal argue that carried interest is a form of earnings that managers receive for their work and therefore should be taxed at the same rates as wages. They contend that it is unfair for these high-income managers to pay a lower tax rate than middle-class workers. Opponents of the proposed legislation maintain that the current tax rules are appropriate because carried interest is no different than other dividends and capital gains. They warn that tax changes in this area could harm investment and economic growth. Various alternative reform plans have also been suggested.

At this AEI event, Fleischer, David A. Weisbach of the University of Chicago Law School, and AEI's Alan D. Viard examined and discussed this complicated issue. AEI's Kevin A. Hassett moderated.

Victor Fleischer
University of Illinois College of Law

Private equity funds bring together investor capital and pass through to each investor a slice of the total gains and losses. Fund managers net a management fee and pass through to themselves a percentage of the total gains, should gains be present. While management fees are treated as ordinary income, the carried interest (managers' share of total gains) is instead taxed as capital-gains proceeds as a result of being a pass-through. The result is that fund managers get much of their labor income taxed at the very low capital gains rate. Carried interest income, it turns out, is the most advantageous form of compensation under the tax code, better than either cash or stock options. The fact that fund managers are taxed lightly has not been a cause for outrage in and of itself. The fact that fund managers are as rich as they are and are nonetheless taxed lightly, on the other hand, has produced a great deal of outrage and has brought about numerous calls for reform.
 
There are several possibilities for reforming the private equity tax scheme. One is to apply ordinary income tax to carried interest as it is granted. That would require a valuation at the time of granting, however, which can be problematic. Another alternative is the implicit loan approach, which views fund money as an interest-free loan from investors to fund partners. With this approach, fund managers are subject to ordinary taxation on the interest payments foregone, while facing capital-gains taxation on their share of the profits. The simplest alternative, meanwhile, is to maintain the status quo and do nothing.
 
Some type of reform needs to take place and the only question is to the scope. Unfortunately, in targeting only publicly traded partnerships, the Blackstone bill fails on the scope count, as firms could choose to remain private and thereby avoid the effects of the bill altogether.
 
Alan D. Viard
AEI
 
The definition of capital gains under the current tax code is simplistic as well as incoherent. Under the current definition, labor income is held completely separate from capital income, and it is presumed that income must entirely fit into one category or the other. Much of the income is actually produced using a mix of both labor and capital. Carried interest income offers us one such example, as it is generated using a combination of fund managers' labor and invested funds. Under current laws, carried income is not categorized as the product of both labor and capital, which it is, and is instead categorized under either one grouping or the other. This, in large part, is the reason we have a problem to begin with.

Despite the definition problem, some argue that all carried interest income ought to be treated as ordinary labor income. If we treat carried interest income in this way, however, it is likely that some other loophole will be found by fund managers, and that the capital gains exemption will be taken advantage of in some other way. The capital gains exemption can be exploited, of course, as a result of how poorly constructed it is in the first place under the tax code.

Under any changes to the carried interest taxation scheme, the Internal Revenue Service stands to gain little revenue, and fund managers will likely continue to face light taxation. Furthermore, while little is to be gained through such a change, much can be lost. To this end, the transactional structure that is likely to emerge under new regulation will probably be far less efficient than what exists today. Thus, under the current definition of capital gains, any change in carried interest taxation is likely to make the situation worse rather than better.

Granted, it certainly does not feel right to let individuals as rich as fund managers get away with paying incredibly low tax rates. Instead of going after rich individuals such as fund managers with narrow, avoidable, and inefficient taxes, as would be the case with carried interest taxes, the government should institute broad-based taxes that apply to all the rich, whether they are fund mangers or not, and that would not be easily avoidable.  
 
David A. Weisbach
University of Chicago Law School
 
There are several silly arguments for and against the current private equity taxation scheme. Among these is the claim that carried interest should be taxed lightly because it is risky. This argument ignores the fact that there are plenty of risky business activities that receive no favorable tax treatment whatsoever. Another claim asserts that carried interest should be treated favorably because private equity provides a public good. Even though private equity produces valuable output, this can be said of most businesses, so it is not clear why private equity deserves to be singled out.
 
One misconception is that all carried interest is treated favorably under the tax code. However, since carried interest is considered to be investment income, only carried interest coming from dividends and long-term capital holdings actually qualifies for a tax benefit. As a result, hedge funds do not always benefit from capital gains discounts and often owe ordinary taxes on carried interest.
 
Some say that the initial fund award ought to be taxed, though they acknowledge the possible liquidity and valuation problems that could arise. Even ignoring these possible complications, however, this sort of initial taxation is not justified. As prepayments for future services, initial awards should not be taxed, and managers should instead be taxed at the time that they engage in work. In receiving a fund award, after all, managers are borrowing against labor income they are due to repay the following year. Because there is an obligation to repay a loan, borrowing does not represent a wealth gain, which means that it should not be subject to taxation.
 
The correct approach is to consider private equity awards as loan transactions. The interest payments foregone can be subject to ordinary taxation, while the carried interest can be taxed as capital gains. This way, managers can be taxed as they work while also being provided an incentive to do this work well. Given the messy income tax system currently in effect, however, there might be no right answer to this problem.

AEI intern Boris Vabson prepared this summary.