Mitt Romney’s release of his tax returns has pushed the arcane issue of “carried interest” — the share of an investment fund’s profits given to its managers as payment for their services – back into the headlines. Critics have renewed their calls to tax the carried interest as ordinary income. Unfortunately, the populist rhetoric used by some critics can obscure the facts about how carried interest is actually taxed.

Some critics assert that all carried interest is taxed at the lower 15 percent that applies to capital gains and dividends. They complain that these funds are able to “turn” ordinary income into capital gains and dividends by paying managers in carried interest rather than salary, and that the funds are exploiting a special loophole not available to other firms. Looking at how carried interest works reveals that none of these things are true.

A private-equity, venture-capital, or hedge fund may earn various types of income — interest, short-term and long-term capital gains, dividends, and profits from non-corporate business holdings. These funds are organized as partnerships, with both the managers and the investors as partners. As a partnership, the fund is not directly taxed on its income. Instead, each partner is taxed on his share of the fund’s income — whether or not he removes it from the firm. 

"Critics have failed to make a good case for imposing special restrictions that would prevent private-equity, venture-capital, and hedge funds from using the tax rules that apply to other industries."--Alan Viard

The managers pay the same tax rate on income from the fund as they would pay if they had earned the same income on their own — channeling the income through the partnership doesn’t change the tax rate. Managers pay 15 percent tax on any carried interest that reflects long-term capital gains or dividends earned by the fund, as they would on any long-term gains or dividends they might earn on their own. But managers pay ordinary income-tax rates on any carried interest that reflects short-term gains, interest, or non-corporate profits earned by the fund. The tax rate depends on the kind of income the fund earns — not all carried interest gets the 15 percent rate.

But, should any of it get that rate? Critics point out that, if the fund had paid its managers a straight salary, the salary would have been taxed as ordinary income. They argue that the fund should not be allowed to “turn” ordinary income into capital gains or dividends simply by paying the managers carried interest rather than salary.

But that’s not what’s going on. The way the fund pays its managers can’t change the total amount of capital gains and dividends or the total amount of ordinary income the fund has earned. Paying carried interest rather than salary simply reallocates the two types of income among the two types of partners — it gives managers more of the gains and dividends and less of the ordinary income while giving the investors less of the gains and dividends and more of the ordinary income. Nothing gets turned into anything else.

To be sure, this reshuffling of income usually produces net tax savings. The managers pay less tax because they get more of the lightly taxed gains and dividends. And the investors are often pension funds that don’t have to pay tax no matter how much ordinary income they’re given.

Critics don’t explain, though, why these tax savings are improper. The funds and managers aren’t exploiting a special loophole — they’re following the same tax rules that apply to everyone else. Because all partnerships may choose how to allocate their income among their partners, any partnership is free to allocate gains and dividends to partners who work rather than those who invest. The funds certainly have good business reasons to pay carried interest rather than salary — that arrangement gives managers the most powerful incentives to maximize performance. And managers who receive carried interest face the same risks as the investors.

These complicated issues could be avoided under a consumption tax or a better-designed income tax. Starting from today’s system, it’s hard to identify a single “right” rule for how partnerships should be allowed to allocate income. But critics have failed to make a good case for imposing special restrictions that would prevent private-equity, venture-capital, and hedge funds from using the tax rules that apply to other industries. Any tax changes that are adopted should apply throughout the economy and should be based on facts rather than populist rhetoric.

Alan D. Viard is a resident scholar at AEI