Carried Interest - A Primer

One of the least-understood proposed tax provisions of the American Jobs Act of 2011 concerns the taxation of “carried interest” of private equity firms.  Is the current tax treatment of carried interest really a tax loophole?  What is a private equity firm?

Private equity firms are limited partnerships that provide a means for the pooled investment of several investors.  A typical structure is a general partner that syndicates the partnership, and several limited partners, usually institutional and wealthy individual investors.  The investment horizon is long-term, typically 10 years.  The general partner performs all necessary research and due diligence to identify qualified acquisitions, while the limited partners provide the funding.  These acquisition targets are typically existing but underfunded or undervalued companies.  The general partner creates value in the acquisition with operational and management expertise as well as requisite funding.  Investments in these targets are typically equity, and the exit strategy is a target IPO or sale of the target to another investor.  The limited partners, by definition, have no control over the management of the partnership.  Their investment is entirely at risk (they may lose it all), and their profit is only realized upon exercise of the exit strategy.

The general partner receives compensation in three ways – salary, performance bonuses, and carried interest.  A more common name for carried interest is “sweat equity”, and is a long-standing tenet of partnership law. The idea is that partners who contribute ideas and talent can participate in equity along with those who contribute only cash.  Upon exercise of the exit strategy, limited partners are paid some hurdle rate of return, say 8%, then remaining gain is typically split, say 20/80, between general and limited partners.  That 20% is the carried interest.  Current law states that the carried interest is a return of investment, and as such is treated as capital gain.  Since the investment is long term, the capital gain is long term.  Currently, the maximum tax rate for long-term capital gains is 15%, whereas the top marginal rate for ordinary income, e.g. salary, is 35%. 

So, general partners in private equity firms are taxed at 35% on salary and bonus, but at only 15% on carried interest.  The current proposal centers on that disparity, and claims that the carried interest is in fact compensation, and should be taxed as such, i.e. at 35%. 

There are several arguments for and against treating carried interest as compensation.  However, current tax law treats carried interest as capital gain.  There are also good arguments (with which I agree) for taxing capital gains at lower rates than ordinary income, but a thorough discussion is beyond the scope of this article.

Most of the arguments in favor of treating carried interest as compensation appear to be emotion-driven.  You need to look no farther than Stephen Schwarzman of private equity firm Blackstone.  Schwarzman is a VERY wealthy individual (and the tax treatment of carried interest has helped to make him so), and is the reigning poster boy for Wall Street excess and conspicuous consumption.  For example, he rented the Armory in NYC for his 60^th birthday party on 2/13/07 which featured a 30 minute private performance by Rod Stewart, who was paid $1M.  Total cost of the party was reportedly $5M.  (Schwarzman also donated $100M to the NY Public Library in 2008, but that didn’t get quite as much press for that.)  On 6/22/07, Schwarzman and partner Peter Peterson took Blackstone public.  Filings with the SEC in connection with the IPO disclosed his income, which at that time was over $1M PER DAY.  Around that same time, a research paper concerning carried interest by an obscure professor, Victor Fleisher, surfaced in the Senate Finance Committee hearings.  It’s no coincidence that Rep. Sander Levin (D-MI) introduced legislation on 6/22/07 to treat carried interest as compensation.  Interestingly, the Treasury Department at that time suggested, both in testimony to Congress and in various speaking engagements, that altering the tax treatment of a single industry raises tax policy concerns and that changing the way partnerships in general are taxed is something that should be done only after careful consideration of the potential impact.

Risk varies with directly reward.  A risk-adverse investor may choose to invest in FDIC-insured CDs, but his reward may be only 1%.  An investor in a private equity fund may have very large upside potential, but could also lose his entire investment. Capital is mobile. Taxing one industry sector at the expense of another may only result in movement of capital without any actual tax benefit. The cost of capital has a tax component that all investors consider.  No change in tax policy should be considered in a vacuum.

Honestly, this entire debate reminds me of Congressional hearings in 1969, where the news of a mere 21 wealthy individuals that paid no income tax at all spurred the creation of the Alternative Minimum Tax.  The root causes were subsequently addressed by legislation, particularly the Tax Reform Act of 1986, but we’re still stuck with the AMT.

By the way, here is a video of a recent appearance of Schwarzman in NC.