Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Finding the Right Balance: A Critical Analysis of the Major Proposals to Reform the Taxation of Carried Interests in Private Equity
Christopher W. Livingston
The booming private equity industry has recently been the subject of a hotly contested tax controversy that has garnered the attention of the media, tax academics, and politicians. The controversy surrounds the taxation of carried interest, which is the share of a private equity fund’s overall profits given to the fund’s managers. Under current tax law, carried interest is ordinarily taxed at the preferential net capital gains rate of 15%. In contrast, compensation earned by regular workers is taxed at ordinary income rates of up to 35%. The divergence between the tax rates levied upon carried interest earned by private equity fund managers and income earned by regular workers is the impetus behind this highly charged debate.
This disparity in tax rates has incited calls for reform by many tax academics and has been the inspiration for proposed legislation in Congress. Supporters of change argue that carried interest is compensation for services and should be taxed as ordinary income. Their proposals seek to raise the rate at which carried interest is taxed to bring it further in line with the rates imposed on regular workers. On the other side, supporters of the status quo charge that increasing the tax rate for carried interest would be inequitable and would have negative effects on the economy. This Comment argues that, in reality, carried interest is not wholly compensation for services or a return on a capital investment, but a combination of the two. As such, carried interest should be taxed in a way that accurately reflects its dual nature. This Comment seeks to bridge this gap and offer an alternative for reform that is within the existing tax framework and comports with the economic realities of carried interest.
Part I provides an introduction to the private equity industry. It illustrates the growing prominence of private equity in the capital markets and explains the funds’ general business model, structure, and compensation scheme. Part II analyzes the current tax treatment of carried interest and its effects, with particular attention paid to the tax treatment of carried interest when granted and the characterization of carried interest when distributed. Part III introduces and critiques three of the most popular proposals for reform: (1) taxing carried interest as property when granted, (2) taxing carried interest as ordinary income when realized, and (3) taxing imputed interest on the implied loan. Part IV proposes to reform the taxation of carried interest using a modified implied loan approach that allows for an interest expense deduction. This approach taxes carried interest based on its economic reality—as part compensation for services and part capital investment—using the existing framework of the Code.