Download PDF Congress is considering a bill that would increase taxes on the carried interest managers of private equity funds, hedge funds, and real estate funds receive. Although the arguments commonly made for the proposed change seem plausible at first glance, most of their plausibility disappears upon further scrutiny because most of these arguments are based on misunderstandings about carried interest and its tax treatment. It would be unwise to adopt this tax increase on investment when there is no compelling case that it will produce a more efficient allocation of capital.
Key points in this Outlook:
A provision to increase the tax on carried interest is currently under consideration in Congress, but the effects of such a change should be examined in closer detail before it goes into effect.
To understand the effects of the provision and what it means, it is important to understand five myths about carried interest and its tax treatment.
Supporters have not made a compelling case that the proposal would lead to a more neutral allocation of capital. In the absence of such a case, the proposal's increase in the overall tax burden on investment is unjustified.
On May 28, the House of Representatives passed the American Jobs and Closing Tax Loopholes Act of 2010, a bill that would make a number of significant tax and spending changes. The Senate is expected to vote on the bill shortly. One provision of the bill would increase the tax rate on the carried interest received by managers of equity funds, hedge funds, and others. As explained below, carried interest is the share of these funds' income paid to the managers as part of their compensation. In this Outlook, we examine the bill's tax increase on carried interest.
Economic theory provides strong support for the view that consumption, not income, is the best tax base. Under a consumption tax, all investment income would face a marginal tax rate of zero, which would remove any disincentives for individuals to save and invest. By increasing overall taxes on investment income, the bill moves the tax system further away from the consumption-tax ideal.
Given that the federal government uses an income tax rather than a consumption tax, it should adopt tax rules that help allocate capital efficiently. In some cases, tax changes that raise the overall tax burden on investment and, thereby, tend to shrink the capital stock can be justified if they promote a more efficient allocation of the (smaller) capital stock. But such changes should be accepted only when there is a compelling case that they will enable a significantly more efficient allocation. Such a case has not been made for this provision.
Private equity funds comprise one of the key sectors that use the carried-interest arrangement. A private equity fund is a partnership. Its limited partners are investors, usually a mix of wealthy individuals, corporations, and tax-exempt organizations, and its general partner is the sponsoring private equity firm. The firm is itself a partnership, in which the managers are general partners. The fund, which may last for ten or more years, owns stakes in a number of portfolio companies at any given time. The stake in each portfolio company may be held for several years and then liquidated. Private equity funds include both buyout funds that purchase established companies and venture capital funds that finance startup companies.
The private equity fund receives the income from holding and selling the portfolio companies. Because the fund is a partnership, the income is allocated among its partners. A common arrangement calls for the sponsoring private equity firm, as the fund's general partner, to receive an annual fixed fee equal to 2 percent of the fund's invested capital and a "carried interest" equal to 20 percent of the fund's income. As the firm's general partners, the managers receive the fee and the carried interest.
Part of the fund's income, and therefore of the managers' carried interest, may consist of ordinary income taxed at a 39.6 percent top rate. In most cases, however, a large portion of the fund's income, and of the carried interest, consists of long-term capital gains and dividends taxed at a 20 percent tax rate.
Proposals for Change
In early 2007, a then-unpublished article by University of Colorado-Boulder law professor Victor Fleischer aroused congressional interest in the issue of whether carried interest, including the portion that consists of dividends and capital gains, should be taxed as ordinary income. In November 2007, June 2008, and December 2009, the House of Representatives passed bills that included provisions to tax carried interest as ordinary income, but the Senate did not approve any of those provisions.
On May 28, the House passed a revised version of the December 2009 bill. Unlike the three previous bills, the revised bill, which would take effect on January 1, 2011, would not apply the full 39.6 percent rate to capital gains and dividends received as carried interest. Under the bill, half of such income would be taxed at 39.6 percent and half at 20 percent in 2011 and 2012; thereafter, three-quarters would be taxed at 39.6 percent and one-quarter at 20 percent. The same tax treatment would apply to capital gains that managers receive from sales of their partnership interests. The bill recognizes that some managers also invest their own money into the fund and would generally preserve the 20 percent tax rate for capital gains and dividends allocated to those investments and for capital gains from the sale of such investments.
Proponents of this change make a simple argument. They contend that the 20 percent tax rate should apply only to capital gains and dividends that arise from the investment of an individual's own money, not to capital gains and dividends that an individual receives as compensation for working. Because carried interest is compensation for the managers' labor, the argument holds, it should be taxed at the same rate as wages; it is unfair that managers pay a lower tax rate on this labor income than their secretaries pay on wages. This rationale explains why the bill would generally allow the 20 percent tax rate when managers invest their own money in the fund but would disallow it when they are compensated for their labor.
Although this argument seems plausible at first glance, much of its plausibility disappears upon further scrutiny. To understand the issues involved in this discussion, it is necessary first to address several myths that have figured in the debate.
Myth One: Private Equity Funds Do Not Produce Real Output
Despite views to the contrary, it is well documented that private equity contributes significant value to firms and the economy. The empirical research shows increased profits, value, and cash flows. The private equity firm typically identifies a company that is underperforming and buys a stake in the company. This transaction generally involves the purchase of convertible securities bought at a discount, as well as board representation for the private equity firm. The firm brings to the table industry and financial modeling and assistance in recruiting, capital allocation, and management well beyond what a typical board member can offer. With these increased resources and expertise, firms can develop more effective goals, strategies, and leverage.
The ability to revive or create a successful business could well be a highly specific skill that would allow the most talented managers to earn very high returns. If such a star system exists, then the private equity organizational form might well maximize the social benefit contributed by the most talented managers because the private equity model allows managers to swoop in, increase the value of an asset, and swoop out. Given the high returns the industry achieves, there clearly is a valuable place in the American economy for such actors.
Myth Two: All Carried Interest Is Taxed at the Capital Gains Rate
Although carried interest that consists of long-term capital gains is currently taxed at the capital gains rate, not all carried interest takes this form. The tax treatment of carried interest is the same as the tax treatment that would apply if the managers had received the income directly as individuals. If the fund sells a portfolio company it has held for more than a year, the resulting profit is long-term capital gain. The managers pay the 20 percent tax rate on their carried-interest share of that profit, just as they would if they had sold the portfolio company as individuals. However, if the fund receives interest income from bonds, the managers pay the 39.6 percent tax rate on their carried-interest share of that income, just as they would if they had received interest income as individuals; this type of carried interest is not taxed at the capital gains rate. (Further, the fixed fees the managers receive are taxed as ordinary income at the 39.6 percent rate.) The fraction of carried interest on which the partner receives the 20 percent rate therefore depends on how much of the fund's income takes the form of capital gains and dividends as opposed to ordinary income.
Myth Three: Private Equity Funds Receive a Special Tax Break
While the tax treatment of carried interest paid to fund managers may seem unusual, it actually follows from partnership tax principles that apply to industries throughout the economy. Internal Revenue Code (IRC) section 702(b) sets forth the general rule that partners are taxed on partnership income in the same manner "as if such item were realized directly from the source from which realized by the partnership." If a furniture store partnership, for example, realizes long-term capital gains or dividends, the partners who receive that income are taxed at the 20 percent rate.
Some critics are troubled by the fact that the carried-interest arrangement allocates part of the fund's capital gains and dividends to the managers when such income "belongs" to the investors who put up the money. It is not clear, of course, why the gains and dividends do not belong to the managers, whose labor helped produce this income. In any case, IRC section 704(a), a rule that also applies throughout the economy, permits the partnership agreement to allocate different items of partnership income and expense in any desired manner. If the furniture store partnership has two partners, one of whom works and the other of whom puts up the money, the partnership agreement may allocate any capital gains and dividends received by the store to the working partner, who would then be taxed at the 20 percent rate on that income.
The provision in the House bill would allow most partnerships throughout the economy to continue to apply the general rule that partners are taxed on partnership income at the same rate as if they had earned the same income directly. The provision would carve out an exception to that rule for only some partners. The affected partners would be those who, at the time they acquired their partnership interest, are reasonably expected to perform "a substantial quantity" of any of the following "investment services": advising about the value of securities, real estate (held for rental or investment), commodities, partnership interests, and related options and derivatives; advising about the desirability of holding such assets; managing, acquiring, or disposing of such assets; arranging financing to acquire such assets; or activities that support the above services. The provision is clearly intended to target managers who receive carried interest from hedge funds, private equity funds, and real estate firms, although it could also affect some other partners. The general partnership rule in IRC section 702(b) would continue to apply to all other partners throughout the economy. It is the provision in the House bill, not current law, that would single out carried interest for special tax treatment.
Myth Four: Carried Interest Is Simply a Means of Tax Avoidance
While carried interest can result in tax savings (as demonstrated in the next myth), it also serves important nontax purposes by giving managers strong incentives to choose the best investments and manage them properly and by helping the firm attract more able managers (who would find this arrangement the most appealing). Fleischer, the most prominent advocate of changing the tax treatment of carried interest, has recognized that carried interest "provides the most powerful incentive to work hard . . . and is considered essential to attracting talented managers." Carried interest would, therefore, likely be used even if it offered no tax savings; indeed, as the University of Chicago's David Weisbach has observed, it was used in years when capital gains and ordinary income were taxed at the same rates.
Because carried interest does usually provide tax savings, tax motivations have probably prompted its increased use to some extent. It also may have attracted more tax-exempt organizations to invest in funds that use this arrangement. (As explained below, the involvement of tax-exempt organizations contributes to the tax savings.) If the provision to change the tax treatment of carried interest is adopted, tax-exempt organizations may have a powerful incentive to take their cash elsewhere. But tax avoidance is not the driving force behind the use of carried interest.
Myth Five: Carried Interest Turns Ordinary Income into Capital Gains
In some ways, this myth goes to the heart of the debate because it concerns exactly how the tax savings from the use of carried interest arise. What are the tax implications of the fact that the fund pays carried interest to its managers rather than a salary?
Consider a fund with one manager, one investor, and $100 of income, all of which is long-term capital gain. Also, assume that the fund simply gives the manager a 20 percent carried interest, ignoring fixed fees and other complicating features of actual compensation arrangements. In this case, the manager receives $20 of the capital gain, and the investor receives the other $80.
Looking at the manager alone, payment via carried interest does appear to treat what would be ordinary income for a typical employee (the wages the investor pays the manager) as capital gains. Because the manager receives carried interest, she is taxed at 20 percent on $20 of capital gain; if a salary had been paid instead, she would have been taxed at 39.6 percent on $20 of wages. (The tax treatment for carried interest on long-term capital gains means the manager saves $3.92 in taxes.) From an overall perspective, however, ordinary income is not converted to capital gain. The fund has $100 of capital gain, and the only question is how to allocate it between the manager and the investor. To get the full picture, we also need to look at the investor. Under the carried-interest arrangement, the investor has $80 of capital gain and no ordinary income from the fund. Had the investor paid the manager a salary of $20 instead, the investor would have received the entire $100 of capital gain and a $20 offset against ordinary income (because the payment of the salary would be an ordinary business expense that could be deducted against the investor's other ordinary income from outside sources).
Relative to the salary alternative, the use of carried interest increases the manager's capital gain by $20 and reduces her ordinary income by $20, while the arrangement has the opposite effect on the investor. At the aggregate level, there is no change in the amount of capital gains and the amount of ordinary income (assuming the investor has outside ordinary income against which to deduct the salary payment). Essentially, the use of carried interest rather than salary simply reallocates the two types of income between the manager and the investor. Carried interest is not guaranteed to yield a net tax saving in every instance. If the investor and the manager are both individuals in the top tax bracket, the manager's $3.92 tax savings are offset by a $3.92 tax increase on the investor. There is no loss to the federal treasury.
In practice, however, carried interest usually leads to a net tax reduction because many investors are tax-exempt organizations that do not pay taxes either on capital gains or ordinary income. In that case, the reallocation of the two types of income reduces net taxes because nothing offsets the manager's tax savings. It is unsurprising, therefore, that the Joint Tax Committee estimates an $18 billion revenue increase from the proposal.
Although carried interest often reduces taxes, the tax savings are not obtained by turning ordinary income into capital gain. Instead, the tax savings are obtained by reallocating the two types of income between managers and investors. Is this reallocation inappropriate?
As stated above, this type of rearrangement is available to any partnership in the economy under the general tax rules of IRC sections 702(b) and 704(a). Nevertheless, the tax savings available to private equity funds are likely to be greater than the tax savings available to other partnerships, such as furniture stores, for three reasons. First, the dollar amounts are larger. Second, capital gains play a much larger role in private equity funds than in other partnerships; in a furniture store partnership, most of the income is likely to be ordinary operating income. Third, tax-exempt organizations provide more of the investment in private equity funds.
Are the Tax Savings Legitimate or Abusive?
Having covered some of the myths that have influenced the debate, it is now possible to address whether the tax savings generated by using carried interest are improper. Should managers and investors be prevented from reallocating the two types of income in this manner?
Tax savings from the use of carried interest are not markedly different from the tax savings that result from a variety of behavioral responses to the capital gains and dividend tax break. The behavioral responses arise because individuals enjoy a tax saving when they receive capital gains and dividends rather than ordinary income, while the tax treatment of different types of income makes little difference to tax-exempt organizations. That difference in treatment has ramifications for asset holdings throughout the economy. Because of the incentives created by the differences in tax treatment, individuals hold more assets yielding capital gains and dividends (such as stocks) than they would in the absence of taxes. Conversely, tax-exempt organizations hold more assets that yield ordinary income (such as bonds) than they would in a world without taxes. That rearrangement of asset holdings increases the tax savings generated by the capital gains and dividend tax break. Like most tax-motivated asset reallocation, this reallocation is, by itself, likely to be inefficient. It is, however, an inevitable consequence of Congress's deciding to offer a tax break for capital gains and dividends that is beneficial to some--but not all--asset holders. And, by directing assets that yield capital gains and dividends to those investors who can benefit from the tax break for such income, this reallocation makes the tax break a more powerful stimulus to the new production of those assets. Aggressively discouraging this reallocation would therefore dilute the effectiveness of the tax break.
To see how similar carried interest is to other asset reallocations, let us return to the previous example of a fund with one manager, one tax-exempt investor, and $100 of income, all of which is long-term capital gain. Supporters of the provision contend that it is improper for the fund to use carried interest to swap the $20 of capital gain between the manager and the tax-exempt investor. Suppose that instead of using carried interest, the manager simply sold bonds that yielded $20 of ordinary interest income taxed at 39.6 percent and bought stocks that yielded $20 of capital gains taxed at 20 percent, while the tax-exempt investor sold stocks and bought bonds. Nobody would consider this portfolio reallocation improper. Yet it provides the manager with the same $3.92 tax savings (with no offsetting tax increase on the tax-exempt investor) as the use of carried interest. If this portfolio reallocation is acceptable, is there any reason to condemn the carried-interest arrangement that yields the same result?
Some argue that a potential reason to condemn the carried-interest arrangement is because the use of carried interest avoids limits that apply to simple portfolio reallocation. A normal investor's tax savings from portfolio reallocation would likely hit a maximum at the point at which she put her entire financial wealth in stocks and reduced her bond holdings to zero. She would then have no more latitude to reduce interest income and increase capital gains. Carried interest permits some tax savings beyond what could be achieved through simple portfolio reallocation because it allows the manager and investor to achieve a larger exchange of ordinary income and capital gains than the manager could accomplish by placing her entire financial wealth in stocks.
Is this extra latitude for income reallocation objectionable? The grounds for objection seem weak. The reallocation is achieved through the use of longstanding partnership tax rules that currently apply throughout the economy and that the bill would leave in place for most of the economy. Also, the managers to whom the gains and dividends are allocated helped generate the gains and dividends. Moreover, the use of carried interest is not primarily driven by tax motivations but is instead motivated by the need to attract skilled managers and provide them with proper incentives. It is unclear why Congress should be concerned about this method of reallocating ordinary income and capital gains income only within particular types of partnerships.
Current Law Imposes Extra Tax Burden on Some Fund Managers
In some cases, the corporate income tax imposes a disguised payroll tax on fund managers' earnings, a payroll tax that does not apply to other workers in the economy. The tax savings from the use of carried interest help offset this disguised tax. The corporate income tax is normally a tax on capital rather than labor because the corporation deducts its wage payments. This deduction cancels out the tax on the value that the corporation reaps from its employees' work. In cases in which the corporation is a portfolio company held by a private equity fund and the fund manager's work increases the corporation's earnings, however, the corporate income tax paid on those extra profits reduces the after-tax value of the manager's work and therefore reduces what the fund will pay her. The corporation cannot deduct the compensation paid to the manager because she is paid by the fund (the corporation's stockholder) rather than the corporation. The result is a disguised payroll tax on the manager that takes the form of lower wages than the manager would otherwise receive.
Of course, there are a number of circumstances in which there is no disguised payroll tax. The portfolio company may not pay corporate income tax, either because it is not a corporate firm or because it is losing money. Alternatively, the manager's labor may consist of buying and selling companies to exploit price discrepancies in securities markets rather than boosting a company's operating profits or may consist of devising better ways for the portfolio company to avoid corporate income tax, perhaps by adding to the company's debt. When the disguised payroll tax does exist, however, the tax savings from the use of carried interest help offset it.
Transition and Expectations
Because the provision in the House bill to change the tax treatment of carried interest would take effect on January 1, 2011, private equity funds with large unrealized capital gains will have a strong incentive to realize their positions during the remaining months of 2010 if the Senate passes the bill with the carried-interest provision intact.
The provision targets an industry that has been particularly successful but that is politically disfavored. This could have a chilling effect on other businesses that may fear being singled out for similar treatment in the future. The demonization of private equity firms associated with efforts to pass this legislation only exacerbates these concerns. From oil companies to health insurance companies to private equity firms, the list of industries targeted for special punitive measures seems to grow each year, a pattern that undermines business confidence.
The provision is also complex in a troubling way. The real problem is not that the provision sets forth a lengthy set of intricate rules--which it does, of course, and which is hardly a boon to the economy. Complexity of that type is common in partnership tax law. Instead, the problem is what is missing from the provision, namely clarifications of some of its fundamental ambiguities. For example, the provision defines the partnership interests to which it would apply as those held by partners who are expected to provide a "substantial quantity" of certain investment services. Despite the high stakes surrounding the question, the provision does not define "substantial." The American Bar Association Section on Taxation and other observers have noted this along with a number of other ambiguities. In 2008, one of us noted that these ambiguities could be "addressed through more careful drafting," but in drafting the legislation, Congress did not take necessary care to address these ambiguities.
Of course, Internal Revenue Service (IRS) regulations are likely to resolve many of these ambiguities eventually; the IRS has a good (and underappreciated) track record of resolving the complexity and ambiguity of the tax laws Congress passes. However, the IRS will not be able to issue all of the necessary clarifications before the provision takes effect at the beginning of 2011.
Congress is considering a proposal to increase the tax on the carried interest received by managers of private equity funds, hedge funds, and other firms. Many of the arguments made for this proposal are based on misconceptions about carried interest and its tax treatment. It would be unwise to adopt this tax increase on investment when there is no compelling case that it would lead to a more efficient allocation of capital.
1. American Jobs and Closing Tax Loopholes Act of 2010, HR 4213, 111th Cong., 2d sess., available at www.opencongress.org/bill/111-h4213/show (accessed June 1, 2010).
2. Parts of this Outlook draw on the earlier analysis in Alan D. Viard, "The Taxation of Carried Interest: Understanding the Issues," National Tax Journal 61, no. 3 (September 2008): 445-60, available at www.aei.org/article/29119.
3. For a discussion, see Robert Carroll, Alan D. Viard, and Scott Ganz, "The X Tax: The Progressive Consumption Tax America Needs?" AEI Tax Policy Outlook (December 2008): 1-2, available at www.aei.org/outlook/29082.
4. For further discussion, see Alan D. Viard, "The Taxation of Carried Interest: Understanding the Issues," 446-47 and the sources cited therein.
5. In 2010, dividends and long-term capital gains are taxed at 15 percent, and ordinary income in the top bracket is taxed at 35 percent. The capital gains rate is scheduled to rise to 20 percent, and the top ordinary tax rate is scheduled to rise to 39.6 percent, starting in 2011. Dividends are scheduled to be taxed at ordinary rates, starting in 2011, but Obama has proposed that they be taxed at the 20 percent rate. For simplicity, we use the 2011 rates, with the assumption that Obama's proposal is adopted, throughout this Outlook.
6. The article was ultimately published as Victor Fleischer, "Two and Twenty: Taxing Partnership Profits in Private Equity Funds," New York University Law Review 83, no. 1 (April 2008): 1-59.
7. The House passed HR 3996 on November 9, 2007, which would have been effective on November 1, 2007. The House passed HR 6275 on June 25, 2008, which would have been effective on June 18, 2008. The House passed HR 4213 on December 9, 2009, which would have been effective on January 1, 2010.
8. See Shai Bernstein, Josh Lerner, Morten Sorensen, and Per Stromberg, "Private Equity and Industry Performance" (Harvard Business School Entrepreneurial Management Working Paper No. 10-045, March 15, 2010); Steven Kaplan and Josh Lerner, "It Ain't Broke: The Past, Present, and Future of Venture Capital," Journal of Applied Corporate Finance 22, no. 2 (Spring 2010); and Steven Kaplan and Antoinette Schoar, "Private Equity Performance: Returns, Persistence, and Capital Flows," Journal of Finance (August 2005).
9. The substantial economic effect rule of Internal Revenue Code (IRC) section 704(b) requires, however, that the allocation of items for tax purposes matches the actual allocation among the partners.
10. Victor Fleischer, "The Missing Preferred Return," The Journal of Corporation Law 31, no. 1 (Fall 2005): 77-117. In particular, see pages 96-97.
11. David A. Weisbach, "The Taxation of Carried Interests in Private Equity," Virginia Law Review 94, no. 3 (May 2008): 726.
12. For more detailed analysis, see Victor Fleischer, "Two and Twenty: Taxing Partnership Profits in Private Equity Funds"; Chris William Sanchirico, "The Tax Advantage of Paying Private Equity Fund Managers: What Is It? Why Is It Bad?" University of Chicago Law Review 75, no. 3 (Summer 2008): 1071-1153; and David A. Weisbach, "The Taxation of Carried Interests in Private Equity," 715-64.
13. The following calculation determines the amount the manager saves in taxes if she receives her income as carried interest instead of as a salary: ($20 x 39.6 percent)-($20 x 20 percent) = $7.92-$4.00 = $3.92.
14. The manager could borrow and use the borrowed money to buy still more stock, but that strategy generally would not yield any tax savings because she could not deduct the interest payments on her borrowing. IRC section 163(d) limits deductible investment-interest expense to the amount of investment income taxed at ordinary rates, thereby preventing interest from being deducted against capital gains and dividends taxed at the 20 percent rate.
15. Of course, the disguised tax could be avoided if the managers were employed directly by the portfolio companies. Alan D. Viard, "The Taxation of Carried Interest: Understanding the Issues," 455, explains why it would be impractical for the managers to be employed by the numerous portfolio companies held by the fund.
16. For a description of the tax measures targeting "big oil," see Alan D. Viard and Amy Roden, "Big Business: The Other Engine of Economic Growth," AEI Tax Policy Outlook (June 2009): 2, available at www.aei.org/outlook/100051.
17. Alan D. Viard, "The Taxation of Carried Interest: Understanding the Issues," 458. In a May 11, 2010, letter to key members of Congress, the American Bar Association Section on Taxation noted that its concerns about the ambiguities in the earlier bills had not been addressed in the December 2009 bill. See American Bar Association to Sander M. Levin, Max S. Baucus, Dave Camp, and Charles E. Grassley, May 11, 2010, available at www.abanet.org/tax/ pubpolicy/2010/051110comments HR4213.pdf (accessed June 3, 2010). The provision in the bill passed by the House on May 28 also leaves most of these concerns unaddressed.