Carried Interest Taxation

The first part of the JCT Report on the tax treatment of carried interests deals with the primary issues addressed by the legislation currently proposed in Congress, mainly whether carried interests should be taxable as compensation income and whether publicly traded private equity partnerships should be taxable as corporations. 

With respect to the first issue, the report catalogs the arguments on both sides of the issue.  The primary points discussed in the report are as follows:

1. Carried interest distributions should be ordinary income because they represent compensation for services rendered by the individuals whose professional skill generates capital income for fund investors. 
2. Carried interest distributions should be taxable by reference to the character of the fund's income, because they represent a sharing of the fund investors' favorable tax treatment between the investors and the manager.  In this regard, the fisc is in the same position as if the investors paid deductible compensation to the manager, because the investors would deduct the compensation against ordinary income and the fund manager would have an equal amount of ordinary income.  The net would be the capital gain taxable at preferential rates to the investors.  The fallacy with this argument is that it assumes that all investors are taxable at the same rates and can fully deduct the compensation deductions, which is not the case.  For example, an individual investor would probably not get the full benefit of a compensation deduction, because of the distinctions between trade or business (deductible under Code section 162) and investment (deductible under section 212) expenses.
3. A carried interest represents a combination of compensation for services and income from the underlying investments (this point reflects Professor Fleischer's argument discussed previously).
4. A carried interest represents capital gain income because the manager earns it by taking a risk on fund performance.  However, the policy for reduced tax rates for capital gains really has nothing to do with taking risks, but more the disposition of a capital asset.  On the other hand, the fund clearly owns a capital asset, and under traditional views of partnership tax, the fund manager, as a partner in the partnership, is considered to own the same assets as the fund.
5. A carried interest is analogous to an entrepreneur's "sweat equity," which is taxable as a capital gain upon exit from the partnership.  We believe that this point is the strongest policy argument for maintaining the existing regime for the taxation of carried interest.  We don't see why the manager of an investment activity (the private equity fund) can't take sweat equity on the front end and get the same treatment as the entrepreneur who starts the business in which the private equity fund invests. 
6. The existing rules should remain in place because raising the effective tax rate on carried interests would change the economics between the investors and the manager, reducing the effective rate of return to the investors.  We believe that this argument is a red herring, affected by the market for capital independent of the tax consequences.
7. The existing rules should remain in place because treating carried interest income as compensation for services would introduce additional complexity to the tax rules, which could creat inefficiences and distortions in the economy.  On the other hand, the perception that similarly situated taxpayers are taxed at disparate rates on the compensation for services might increase noncompliance by taxpayers who viewed that disparity as unfair.

With respect to the taxation of publicly traded fund manager partnerships is whether a business that derives its income from asset management and advisory services should be treated as a passive investment partnership that is exempt from taxation of a corporation.  (For a background of the publicly traded partnership rules, see here.)  While the legislation clearly exempts carried interests, the report speculates that Congress didn't focus on these types of partnerships, because only a few types of businesses had organized as publicly traded partnership (like the Boston Celtics). 

Tomorrow, we'll report on the second part of the JCT Report, detailing the use of foreign private equity entities by tax exempt investors (universities, pension plans, etc.) to avoid the taxation of returns to those investors because of the use of leverage by the funds.