The taxation of carried interest
Understanding the issues

The Taxation of Carried Interest

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Congress has recently considered taxing the "carried interest" of private equity fund managers as ordinary income rather than at the 15 percent rate that currently applies to a portion of this income. The case for such proposals is less compelling than initial appearances suggest. The proper treatment of carried interest depends upon a number of unresolved economic issues.

In the spring of 2007, a then-unpublished law review article by Victor Fleischer helped turn an obscure aspect of partnership taxation into a contentious tax policy issue. Intense media and political debate took place on the appropriate tax treatment of the "carried interest" received by managers of private equity funds. Although no changes have yet been made to current law, the issue is likely to resurface in 2009.

Carried interest is a share, allocated to the fund managers, of the income generated by the fund's holdings in its portfolio companies. When that income consists of qualified dividends or long-term capital gains, the managers are taxed at the 15 percent rate applicable to those forms of income. The case for reform is simply stated: Since the managers are being compensated for their labor, the payments should be taxed at the same rates as other labor income rather than at the lower rate for dividends and capital gains. Put more strongly, managers' labor income should not be taxed at a lower marginal rate than their secretaries' labor income.

Despite its initial appeal, the case for reform becomes more uncertain upon closer examination. The appropriate treatment of carried interest raises difficult second-best questions. . . .

Alan D. Viard is a resident scholar at AEI.

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