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The Carried Interest Controversy

Posted on September 18, 2017 by Jeremy A. Mandell

Jeremy A. Mandell is a 2017 graduate of the University of Illinois College of Law. In this article, Mandell reviews the history of carried interest and suggests a proper way to tax it. This article was a winning entry in Tax Analysts’ annual student writing competition.


I. Introduction

Carried interest has received increasing attention since 2007 and has been a topic of discussion in the last three presidential elections. A tax preference available to private equity and hedge fund managers, carried interest has been under attack, with politicians and academics offering proposals to eliminate or reduce the preference. With the election of Donald Trump and a majority Republican Congress, carried interest will likely see some kind of change in the near future.

This article suggests an appropriate way to tax carried interest, with a focus on private equity firms.

II. What Is Carried Interest, and How Is It Taxed?

A. What Is It?

Carried interest is a term of art.1 Neither the code nor regulations define it.2 The term originated in the shipping industry in the 12th century, when ship owners and captains were given an interest in the cargo they carried — usually a 20 percent commission. This practice provided shippers an incentive to keep an eye on their cargo.3 Today, carried interest refers to a money manager’s fee based on the appreciation or gain he provides his clients. However, it’s not that simple.

Carried interest applies to partnerships4 and the profits realized by them. It applies specifically to the managing partner’s5 share. The managing partner’s profit interest is usually set at 20 percent, and that sum is called the “promote,” “carry,” or “carried interest.”6For private equity funds, carried interest refers to the profits managing partners receive upon the sale of the fund’s portfolio companies.

Private equity funds operate by purchasing struggling companies with private capital from a fixed number of investors (limited partners). Unlike investors in public companies, who can be infinite in number and can buy and sell as they please, limited partners are contractually obligated to keep their funds invested in whatever assets the fund selects.7 This agreement allows what are often illiquid assets to mature and grow over time, hopefully with appreciation upon their eventual disposition. Alternatively, the private equity fund may take the company public and distribute to the partners the proceeds from selling the company’s securities.8 Before diving into the specific tax treatment of carried interest, it is important to better understand how private equity funds are organized.

B. The Organization of Private Equity Funds

Most private equity funds are organized as either limited partnerships or limited liability companies.9 Capital is injected into the fund through investors, who act as passive limited partners. The general partners are then responsible for managing this capital, which they do by selecting favorable companies to acquire; fixing the organization, management, and business model of those acquired companies; and finally either selling to a strategic buyer or taking the companies public.

In return for managing the fund, general partners typically receive an annual management fee of about 2 percent of the committed capital, as well as a right to share in the profits. General partners’ profit-sharing rights — their carried interest — is often 20 percent, while limited partners split the remaining 80 percent. Private equity funds are typically leanly staffed, meaning their upside is split between few individuals.10 This model is consistent across hedge funds (which focus on short-term liquid investments) and private equity funds. However, competition has forced many hedge funds to forgo the management fee entirely, which is something to look out for in private equity, as well.11

General partners typically have some skin in the game, though a relatively small amount, ranging from 1 to 5 percent of the total capital in the fund.12 Between general partners’ carried interest upside and some (albeit little) capital contribution risk, their incentives are better aligned with the limited partners’ interests. Not to mention if the portfolio fund does poorly, the general partners are out of luck when it comes to realizing any profit — although, of course, the limited partners are financially hit the hardest. This makes the general partners’ role of providing (hopefully) skilled management expertise and labor significant to the partnership.

C. Tax Treatment

Because almost all private equity funds are organized as partnerships or LLCs, they are treated as passthrough entities for tax purposes. The partnership thus avoids corporate taxes, instead passing the tax liability on to its partners as individuals relative to their pro rata share of the fund, as determined by the partnership agreement.13 The character of that income — whether it is ordinary income or long-term capital gain or loss, is retained — allowing the general partners and limited partners to pay at their respective capital gains rates if the partnership’s assets qualify as such.14 Since the average hold time for private equity assets is five-and-a-half years — far longer than the one-year holding requirement for long-term capital gains treatment — when those assets are sold, they retain and pass on their preferential capital gains rate to the partners.15

Passthrough taxation dictates how the two sources of a private equity partner’s income will be taxed. Professor Victor Fleischer, in his seminal 2008 article bringing attention to carried interest, termed the private equity compensation structure the “two and twenty” standard.16 This reflects the common 2 percent management fee and 20 percent carried interest profit sharing.

The management fee is taxed as ordinary income to the general partner, creating a federal tax liability as high as 39.6 percent.17 This fee is considered ordinary income because it is used for administrative costs, diligence, and managers’ salaries.18 However, carried interest is taxed like any other capital asset, and if held for the requisite period, it will receive capital gains treatment. Assuming general partners are in the top income bracket when the partnership sells an asset, those partners stand to make millions, taxed at only 20 percent.

Therein lies the controversy. Those opposed to the carried interest “loophole” argue there is no reason for wealthy millionaires performing a task similar to an investment adviser (whose salary is taxed as ordinary income) to receive special tax treatment. This argument also relates the managing partner’s responsibilities to labor income, with little risk (relative to their personal contribution) associated with the asset’s underperformance.

On the other hand, proponents for carried interest analogize the general partner’s contribution to an entrepreneur’s sweat equity, which our system rewards with lower capital asset tax rates. Supporters reason that the general partner’s current tax treatment is no different than that of a taxpayer who purchases a house, improves it — by painting, plumbing, or putting up drywall, for example — and sells it a year later, thus qualifying the asset for capital gains treatment even though the taxpayer’s labor likely contributed to some of the gain.19

Before discussing the proper way to tax carried interest, a couple of points should be made. First, the term “loophole” is not the result of anything actually written in the code. As mentioned earlier, the term “carried interest” is nowhere to be found in the tax code or its regulations.20 When politicians suggest closing the “carried interest loophole,” what they really mean is they want to create an amendment to the tax code that would treat private equity and hedge fund managers differently from their limited partner counterparts. That is justified by claiming that the current treatment of general partners is unfair, even though it is consistent with the code and partnership taxation.

This raises the second point, which requires a further examination of partnership taxation. Although general partners receive something of value when they sign a partnership agreement, their carried interest benefit is not treated as a taxable event at signing. The tax is deferred partly because of how difficult it is to determine the value of that benefit.21(Carried interest deferral differs from corporate equity compensation, for which fair market value is more easily ascertained.) As a result, general partners benefit from deferred taxation and are responsible for the bill only upon receipt of the carry.

Treasury released Rev. Proc. 93-27, 1993-2 C.B. 343, which confirmed that profit interests are a nontaxable event if: (1) the partnership’s income stream is not substantially certain and predictable; (2) the partnership is not a publicly traded company; and (3) the profits interest is retained for more than two years. Those factors are easily met in most circumstances, and as a result, general partners benefit from the time value of money. Taxes paid tomorrow are worth less than the same taxes paid today. Alternatively, if general partners take a loss, that amount is substantially smaller (between 1 and 5 percent) than what they stand to gain (usually 20 percent), so any deferred taxable loss will be a smaller amount.22

Looking at the partnership as a whole, if the limited partners are taxable investors, the deferred taxation rules balance out. The partnership is unable to deduct the profits interest conferred to the general partners at the time of signing, and the limited partners are unable to take advantage of the deductions themselves. If, however, the limited partners are tax exempt (which they often are, with capital coming from pension funds or university donations), the partnership will benefit because the general partners can defer paying taxes without the limited partners paying a corresponding substitute tax. In the aggregate, therefore, the partnership benefits and the government loses revenue. However, this is no different from a nonprofit receiving tax-exempt status.23

III. The History of Carried Interest

Carried interest came into the modern era in the 1920s through the oil and gas industry. Because of the immense amount of capital necessary to explore, develop, and drill for oil, the industry organized as partnerships, split between wealthy investors and sweat-equity managers. When the partners left, the sale of their interest was treated as a capital asset and taxed at the lower capital gains rate.24 That system was adopted in the 1954 code, which, for the first time, provided the tax treatment for numerous transactions in partnerships.25 Before 1954, partnership tax was considered “one of the most complex and confused subjects in the entire area of income tax.”26

The 1954 code set out to create a uniform system of partnership taxation using case law to develop its jurisprudence. Accordingly, section 741 came into existence. Section 741 characterizes partnership interests as assets distinct from the assets of the partnership itself — and that interest is subject to capital asset treatment. Under the 1939 code, the tax treatment of profits received from a withdrawing partner was determined on an asset-by-asset basis. If the partners had been compensated based exclusively on their share of receivables, their interests would be treated as ordinary income. Courts battled with that notion, consistently holding that partnerships were more than collections of assets and should be viewed as entities.27 The entity theory of partnership makes the composition of an individual partner’s interest irrelevant, providing a justification for treating that interest as a capital asset.

Over time, more industries took note of the tax benefits derived from the partnership structure. Initially, real estate and venture capital firms organized as partnerships for this purpose.28 Private equity firms followed suit. In the 1950s and ’60s, private equity was a much smaller industry, composed mostly of wealthy, risk-seeking individuals.29 Today, private equity is one of the most profitable sectors in the financial industry. At least 18 private equity firm executives have a net worth exceeding $2 billion.30

For a long time, partnership taxation was largely ignored by the public. Part of this stemmed from Ronald Reagan’s tax reform deal in 1986, which equalized the capital gains rate with the highest ordinary income tax bracket rate. Without an opportunity for gamesmanship, carried interest was no longer an issue. George H.W. Bush, however, raised taxes on ordinary income, as did Bill Clinton. In 1997 Clinton also significantly reduced the capital gains tax. When George W. Bush was in office, he further reduced tax rates across the board, renewing the incentive to characterize carried interest as a capital asset.31

Carried interest was brought to the public’s attention in 2007, when Fleischer’s pivotal “Two and Twenty” article circulated in draft form. That article challenged the current carried interest tax treatment. Fleischer maintained that carried interest is the income that private equity managers are paid for doing their job. The only reason it’s not taxed as income, he argued, is because of outdated code provisions.32 In an interview with The New Yorker’s Alec MacGillis, Fleischer said, “It’s important to think about how the tax system treats people. The tax system has to fund the government and the government has to do things for everyone.”33

Since Fleischer’s “Two and Twenty” article, Congress has attempted to reform carried interest’s preferential treatment. In October 2007 then-Rep. Charles B. Rangel introduced a bill adding section 710 to the code.34 Subject to various requirements and exclusions, that provision would have treated 75 percent of the service partner’s carried interest as ordinary income and allowed the remaining 25 percent to retain its passthrough character.35 The proposed amendment also would have increased tax revenue by eliminating the opportunity for partnerships to deduct the general partner’s salary.36 However, section 710 was either too complex, poorly executed, arbitrary, or too focused on an unpopular agenda because the proposal failed to garner enough support.37

Despite section 710’s failure, carried interest received attention yet again during the 2012 presidential election.38 Republican presidential candidate Mitt Romney came under attack for the tax advantage he received as co-founder of Bain Capital, a private equity firm. At the time, incumbent Barack Obama pledged to reform the carried interest loophole; however, reform failed to materialize.39 In the 2016 presidential race, Sen. Bernie Sanders, I-Vt., Hillary Clinton, Trump, and Jeb Bush all agreed on the need to change how carried interest is treated.40 In fact, Clinton even stated that she would take executive action and request that Treasury close the loophole.41

IV. Classifying Capital Assets

Whether one agrees with how carried interest is treated hinges on two factors. The first is whether one believes in the need to reward entrepreneurs through capital gains treatment. The idea behind a lowered capital gains rate is that it will encourage entrepreneurs to take risks, which could result in job creation and aid the economy. Capital gains treatment helps encourage those individuals, rewarding their successful outcomes with a reduction in their tax burden.42 Of course, this is just an economic theory, with far too many variables to determine its validity.

Regardless of capital gains’ alleged positive relationship to the economy, the fact that it provides a preferential rate gives general partners an incentive to classify carried interest as capital gain. The easiest way to eliminate this incentive, MacGillis explained, is “to close the loophole [and] equalize the rates on capital gains and regular income, as was done in 1986, but this would encounter staunch Republican opposition in a legislative fight.”43 Omitting a capital gains preference would certainly moot the carried interest debate; however, this article does not attempt to defend or support long-term capital gains treatment.

Given a capital gains preference, the next question is whether carried interest should qualify for that preference. This is an issue of classification. While most scholars focus on the distinction between labor and the investment aspect of general partners in private equity, the better question is whether a general partner’s particular activity fits the definition of a capital asset.

Section 1221(a) provides:

The term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include —

(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

(2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business; . . .

(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1); . . .

(8) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer.

A basic requirement for a capital asset is that it be property held (that is, invested) by the taxpayer.44 Based on Rev. Proc. 93-27, which outlines the IRS’s approach to deferring receipt of a partnership profits interest until it vests, it is undisputed that carried interest (that is, a profits interest) should be treated as property.45 The next limitation to a capital asset is found in subsection 1221(a)(1), which excludes property that either would properly be included as inventory or is primarily for sale to customers in the ordinary course of business.46 This is a start; however, without more context, these terms are less than concrete. Accordingly, it is necessary to review case law to flesh out what constitutes a capital asset.

In Mauldin,47 the taxpayer (C.E. Mauldin) bought a large piece of land in New Mexico for a prospective cattle business. After a change in market conditions, he decided against the cattle business and instead divided the land into tracts that he aggressively proceeded to sell. At one point, Mauldin slowed down his selling spree and went full time into the lumber industry. On his income tax returns, Mauldin showed the lots sold as long-term capital gains, and he paid his taxes accordingly. The IRS challenged that classification and filed a deficiency suit to force Mauldin to pay the balance.

In deciding Mauldin, the court took a holistic approach, stating, “There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by him primarily for sale to customers in the ordinary course of his trade or business.” The record showed he sold more lots on a sellers’ market than he did on a buyers’ market and that a substantial part of his total income came from those sales. Therefore, the court held that Mauldin was in the real estate business, and his profits were thus subject to ordinary income treatment.

However, what if, instead of purchasing one plot of land and splitting it into multiple lots, Mauldin had bought multiple plots in different cities, each with an existing business on it? Let’s further assume he secured ownership of those businesses, restored them — some successfully and others not — and later sold the lots (with the businesses on top of them) at different times, more than a year after their acquisition. While the Mauldin court would take some factors into consideration, such as the percentage of income derived from the sale and the nature of those sales, this hypothetical clearly involves more than simply selling inventory. In fact, the effort involved in locating the establishments, improving them, and finally selling each to a strategic buyer is no different from an entrepreneur purchasing stock in a company and doing the same — or from a taxpayer purchasing, improving, and selling a home a year later, which the code taxes as capital gain or loss.48

To better relate the hypothetical to private equity, assume many individuals purchased lots, each with different compensation schemes based on the business’s eventual performance when sold and the individual’s involvement with that business. The financing of each business is structured through third parties, or limited partners, and partnership taxation provides that an investment held as a capital asset is entitled to capital gain or loss treatment, even if paid for by third parties.49 In this simplified private equity analogue, it seems impractical to consider the collection of unrelated, non-fungible businesses as inventory.

Admittedly, the issue continues to revolve around the question of what constitutes a capital asset. Further, Mauldin was not about inventory but whether the taxpayer’s transactions qualified as part of his trade or business. If it is not inventory, can carried interest be considered property “primarily for sale to customers in the ordinary course of his trade or business?”50 Fourteen years after Mauldin, the Supreme Court in Malat 51 clarified the term “primarily” in subsection 1221(a)(1). The Court interpreted the term to mean “of first importance” or “principally.” Although the Supreme Court provided a rather unhelpful definition, it happens to carry weight in the private equity context. The “primary” purpose of acquiring a portfolio company in private equity is to increase its value. Of course, an increase in value will translate to realized gains upon its eventual disposition; however, time and effort are undeniably necessary for that success. Before selling the business to “customers,” it is “of first importance” that it grow and prosper.

Distinguishing the primary purpose of the taxpayer in Mauldin and that of a traditional private equity firm is the fact that when Mauldin’s plan changed, so did his primary purpose. After determining that the market could no longer support his purported purpose (the cattle farm), it was “of first importance” that Mauldin divide and dispose of his property. With portfolio companies in a private equity firm, the primary purpose is always to add value first and retain the asset until it has appreciated in value.52 This method (the order of importance to private equity funds) is distinct from Mauldin’s lone (although delayed) purpose of simply disposing of his property. Between the inventory analogy and “ordinary course” analysis, a strong argument can be made that carried interest falls outside the exception listed in subsection 1221(a)(1).

However, section 1221 includes eight subsections that list what is excluded from classification as a capital asset. Four subsections are clearly inapplicable, absent unique circumstances, such as: a copyright; a literary, musical, or artistic composition; a publication of the U.S. government; any commodities derivative financial instrument held by a commodities derivatives dealer; or any hedging transaction clearly identified as such.53 This leaves three additional, potentially relevant subsections that should be subject to scrutiny.

The second exclusion, subsection 1221(a)(2), triggers any profit generated from the sale of “property, used in his trade or business . . . which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business” to be taxed as ordinary income. An IRS publication provides guidelines to clarify capital assets versus noncapital assets.54 In that publication, the IRS reduces subsection 1221(a)(2) to “depreciable property used in your trade or business or as rental property.” Thus, this subsection captures property used to generate revenue within a business, such as a textile machine used to manufacture clothes or an apartment rented to generate income. Because portfolio companies (in their entirety) are not subject to depreciation, this exception does not apply.

The third exclusion, subsection 1221(a)(4), was enacted in 1954 to correct a loophole allowing taxpayers to treat the value of accounts or notes receivable “acquired for rendering services or selling inventory” as ordinary income. But upon later disposition, its subsequent sale was allowed capital treatment. The legislative history validates this interpretation, providing an example: “Under [then] present law this difference would be capital gain unless the taxpayer is such a dealer. The amendment will cause such gain to be ordinary income.”55 The focus of the amendment was limited in scope, since it set out to simply eliminate the opportunity to reclassify what section 1221(a)(1) already determined to be ordinary income. Having determined that carried interest is excepted from section 1221(a)(1), this subsection is inapplicable.

Finally, subsection 1221(a)(8) treats “supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business” as a noncapital asset. Section 41 defines the term “supplies” to mean “any tangible property other than — (i) land or improvements to land, and (ii) property of a character subject to the allowance for depreciation.”56 This exception is relatively straightforward: Any physical tool necessary or nondepreciable property used for general partners to conduct their business, when sold, is taxed as ordinary income. This might include a computer (assuming it cannot be depreciated) used for business purposes and sold after one year. Because carried interest is intangible and cannot be used or consumed, this subsection is immaterial to determining the classification of carried interest.

Most scholars, even those advocating the need to change the classification of carried interest, acknowledge carried interest as a capital asset.57 While there are certainly arguments for ordinary income treatment under section 1221(a)(1), the IRS has consistently treated the receipt of carried interest as a nontaxable event and its ultimate income as a capital gain or loss.58 In Dagres,59 the court affirmed that “investors who invest their own funds in public companies or in privately held companies . . . are investing, not conducting a trade or business, even when they make their entire living by investing.” Also, an equally accepted principle is the irrelevance of investing one’s own money or that of a third party.60If a better argument could substitute for this analysis and subject carried interest to ordinary income taxation, Treasury surely would have found it by now.

Therefore, if carried interest falls within section 1221’s definition of a capital asset, any argument against preferential treatment essentially stems from notions of fairness. As professor Howard Abrams framed it, “Hedge fund and private equity managers make too much money, and it pours salt in the wounds when their tax rate is lower than everyone else’s.”61 This shift from a mechanical argument to a fundamental one concerning the purpose of taxation elicits the question: How should carried interest be taxed?

V. Carried Interest Proposals

Since Fleischer’s article circulated in draft form in 2007, carried interest has gotten considerable attention.62 Countless proposals from academics to politicians have been offered — some suggesting change, others favoring the status quo. Rather than recapitulating Fleischer’s already comprehensive set of alternatives, this article discusses three viable proposals: the ordinary income method, the cost of capital method (for which credit goes entirely to Fleischer), and the status quo.

A. The Ordinary Income Method

Fleischer identified two central issues resulting from the capital asset treatment of carried interest: the timing of taxes due (that is, the benefit of deferral) and the character of carried interest.63 Because of the difficulty of determining the value of a carried interest before the sale of its portfolio company, the IRS provided a safe harbor that treats the receipt of most partnership profits interests as a nontaxable event.64 Thus, general partners benefit from the time value of money (to the federal government’s detriment).

The second issue, which, on its face, may also seem to reduce tax revenue, is more about fairness. If both limited partners and general partners are in the same tax bracket, treating general partners’ carry as ordinary income would allow limited partners to take an offsetting deduction.65 Limited partners would of course continue to receive capital gains treatment on their investment. In effect, according to Abrams, an ordinary income tax on general partners would simply “shift income among partners but will not change the net income they report in the aggregate.”66 However, if some limited partners are tax exempt, recharacterization would benefit the government, since general partners would contribute a larger share (likely 39.6 percent) than they otherwise would through the status quo (20 percent).67

This method is an easy sell for those who want to “stick it to the man.” And given the composition of many limited partners, an ordinary income approach would also increase tax revenue.68 Quite possibly the simplest approach, taxing carried interest at ordinary income rates is unsurprisingly one of the most popular suggestions among oppositionists.

In June 2015 Rep. Sander Levin, D-Mich., and Sen. Tammy Baldwin, D-Wis., introduced the Carried Interest Fairness Act, which would treat carried interest as ordinary income.69 The bill had four original cosponsors in the Senate (S. 1686) and eight original cosponsors in the House (H.R. 2889), all Democrats.70 It has 70 cosponsors in total (69 Democrats, plus Sanders). This legislation was not the first of its kind, and similar proposals have in fact passed in the House. In July 2015, Fleischer wrote in The New York Times that he predicted the bill had “a slim chance of passing on its own in this Congress.”71

Fleischer’s prediction is still relevant, since the 2016 elections allowed Congress to retain its Republican composition. Apart from Congress, however, the elections produced an unexpected result: President Donald Trump. Throughout the election, Trump vowed to tax investment fund managers’ profits interest at ordinary income rates.72 Whether Trump’s proposal was sincere is impossible to determine; many politicians have made similar promises, although all fell short.73 However, Trump has stated his desire for comprehensive tax reform, including lowering taxes considerably.74

In June 2016 House Speaker Paul D. Ryan, R-Wis., released “Better Way,” also known as the House Republicans’ blueprint for tax reform. The blueprint in many ways parallels Trump’s revised tax plan, which was released in September 2016.75 As it relates to carried interest, the House GOP proposal would tax passthrough income at up to 25 percent and cut capital gains and dividends income tax to 16.5 percent (carried interest would be treated as the former), thus retaining a tax rate differential.76 The Urban-Brookings Tax Policy Center’s analysis shows that the House GOP plan would heavily benefit the highest-income households.77 Under the blueprint, House GOP tax reform would largely go unnoticed by the bottom 80 percent of Americans, whose after-tax income, if altered, would see less than a 1 percent change. However, those in the top 1 percent — households with incomes greater than $700,000 a year — would see a 13 percent increase in after-tax income in 2017.78

Both the blueprint and Trump’s revised tax plan would create a three-tiered tax bracket system, with rates of 12 percent, 25 percent, and 33 percent.79 Separate from Ryan’s proposal, Trump’s plan would tax carried interest as ordinary income. Because carried interest would be subject to ordinary income treatment, general partners could expect to pay a 33 percent tax, since the highest tax bracket applies to incomes greater than $225,000 for married couples, or $112,500 for everyone else.80 In effect, both plans would increase the tax on carried interest, although the tax itself would vary by 8 percent. With Republican control in both chambers of Congress and a Trump presidency, there is a high likelihood that one or both of these plans will pass.81

Fleischer identified one potential weakness of the ordinary income method: With advanced planning, general partners could recharacterize much of their carried interest by securing a nonrecourse loan from the fund’s limited partners. The nonrecourse loan would amount to 20 percent of the capital in the fund (or whatever percentage the parties negotiated), which general partners would then use to purchase an equity interest in the fund. Because the loan would be structured to replicate the general partners’ carried interest, any lack of imputed interest from the loan would be subject to taxation under section 7872. The remainder of appreciation on the equity interest would receive capital gains treatment, thus avoiding much of the ordinary income tax.82

B. The Cost of Capital Method

What Fleischer identified as a weakness of the ordinary income approach is the basis for his cost of capital method. This method also addresses issues with deferral and the characterization of carried interest. Fleischer would characterize a general partner’s carried interest as a compensatory loan and assess general partners an annual cost of capital charge as ordinary income. That charge would be based on market interest rates, levying the general partner’s percentage of profits interest times the total capital under management. Because of the nonrecourse nature of the loan, as well as its heightened risk, the interest rate should be rather high. Given the difficulty of determining the cost of capital, Fleischer suggests using section 7872 and applying normal federal interest rates.83

For example, let’s assume market interest rates are at 4 percent, the total capital in the fund is $100 million, and the general partner’s profits interest is 20 percent. Twenty percent of $100 million ($20 million) times 4 percent equals $800,000 of taxable income. Using Fleischer’s cost of capital approach, the general partner would therefore be responsible for paying ordinary income tax on $800,000 annually. Once the portfolio company is sold, any appreciation of the general partner’s profits interest would be taxed as capital gains. This method leaves little room for gamesmanship and would neutralize the “windfall” tax benefits general partners receive. Still, the cost of capital method is complex and would be difficult to administer.84

For those who believe some part of carried interest should be taxed differently, this approach justifies an arbitrary but reasonable sum being taxed as ordinary income. One proposed modification would allow the general partner’s annual interest payments to be deferred until the eventual realization of the carry. Although deferral fails to accomplish one of Fleischer’s objectives, it better connects the general partner’s tax burden to the profitability of the partnership.85 It also addresses any liquidity problems that may arise from annual taxation.

C. The Status Quo

Finally, there is always the status quo. Those comfortable with the preferential tax treatment given to capital assets — that is, those who find no distinction between other property that receives that treatment and carried interest — should not take issue with the current system. This assumes the incentives behind current carried interest taxation encourage entrepreneurship and help grow the economy. Any change in its taxation thus stems from notions of fairness, which, given the risk and uncertainty of carried interest, could be viewed as perfectly reasonable.86 The current system is also simple and predictable, and it eliminates the need for valuation estimates. Because the status quo provides the greatest tax benefit to general partners, there is no need for them to bend the rules, so gamesmanship is largely avoided.87

The downsides to carried interest’s current taxation are indicated throughout this article. Because fund managers are given preferential rates, the code encourages investment fund activity without justifying why this occupation needs that subsidy. Moreover, general partners circumvent the progressive nature of our tax system — although so does everyone else who takes advantage of capital gains treatment.88 Perhaps the most compelling argument against the status quo came from President Obama. At a Business Roundtable event in 2015, he told executives, “Keeping this tax loophole, which leads to folks who are doing very well paying lower rates than their secretaries, is not in any demonstrable way improving our economy.”89 Obama’s message mirrored a similar statement made by Warren Buffett in reference to capital gains.90

VI. Recommendation

The current political climate suggests that amendments to carried interest are on the horizon.91 This should come as no surprise, given that the frequently amended tax code grew by almost 3,000 pages between 2010 and 2014.92 While it seems evident that carried interest is consistent with the code, public opinion is that it should be treated less favorably.93

If the ordinary income method were adopted, general partners would have an incentive to recharacterize their carried interest by obtaining a nonrecourse loan from limited partners in their partnership.94 This would result in a pseudo cost of capital approach, which still subjects general partners to a larger tax than under current law.95 Whether one agrees with the need to classify general partners’ contribution as “labor” subject to ordinary income, it appears that at least some part of it will be characterized that way.

Treasury and the Joint Committee on Taxation have estimated that taxing carried interest at ordinary income rates would raise about $18 billion over 10 years. Fleischer found the government’s estimates to be considerably low, since his estimates predict a $180 billion increase in revenue over 10 years. He attributed the variance in estimates to the lack of separate reporting of carried interest and “the anticipated behavioral response to the tax change.” The government assumes general partners will hold on to their carried interest to avoid realizing the income, while Fleischer maintains that general partners simply cannot afford to delay the sale of a portfolio company merely for tax purposes.96

In either scenario, both estimates contribute a relatively insignificant sum compared with the $3.2 trillion raised in taxes in 2015.97 If the focus were on raising revenue, eliminating all capital gains treatment would generate $1.34 trillion over 10 years.98 Thus, taxing carried interest as ordinary income — or changing its tax structure at all — is not the most fitting approach for increasing federal revenue. Rather, it adopts a popular viewpoint on what the public considers to be fair.


1 Nina Krauthamer, Philip R. Hirschfeld, and Kenneth Lobo, “U.S. Taxation of Carried Interest,” 2 Insights 33 (2015).

2 Howard E. Abrams, “Taxation of Carried Interests: The Reform That Did Not Happen,” 40 Loy. U. Chi. L. J. 197, 201 (2009).

3 Paul Solman, “Is Carried Interest Simply a Tax Break for the Ultra Rich?” PBS, Oct. 29, 2015.

4 Or other entities treated as partnerships for tax purposes.

5 Also known as general partners, they handle the limited partner’s capital. Throughout this article, I use the terms “general partners” and “managing partners” interchangeably.

6 Victor Fleischer, “Two and Twenty: Taxing Partnership Profits in Private Equity Funds,” 83 N.Y.U.L. Rev. 1, 3 (2008).

7 Note, “Taxing Partnership Profits Interests: The Carried Interest Problem,” 124 Harv. L. Rev.1773, 1776 (2011).

8 Fleischer, supra note 6, at 9.

9 Id. at 8.

10 Id. at 9.

11 Juliet Chung, “Hedge Funds Take Another Punch to Gut,” The Wall Street Journal, Sept. 26, 2016.

12 Fleischer, supra note 6, at 8.

13 Id.

14 Note, supra note 6, at 1784.

15 Amy Or, “Average Private Equity Hold Times Drop to 5.5 Years,” The Wall Street Journal, June 10, 2015.

16 Fleischer, supra note 6, at 8.

17 Note, supra note 7, at 1777; section 1.

18 Fleischer, supra note 6, at 9.

19 Abrams, supra note 2, at 198.

20 Id. at 201.

21 Fleischer, supra note 6, at 10.

22 Id. at 12.

23 Id. at 13.

24 Alec MacGillis, “The Billionaires’ Loophole,” The New Yorker, Mar. 14, 2016.

25 Robert S. Ashby and Albert L. Rabb Jr., “The Drafting of Partnership Agreements Under the 1954 Internal Revenue Code,” 31 Ind. L. J. 45 (1955); see also J. Paul Jackson et al., “The Internal Revenue Code of 1954: Partnerships,” 54 Colum. L. Rev. 1183 (1954).

26 Jackson et al., “A Proposed Revision of the Federal Income Tax Treatment of Partnerships and Partners — American Law Institute Draft,” 9 Tax L. Rev. 109, 112 (1954).

27 John A. Lynch Jr., “Taxation of the Disposition of Partnership Interests: Time to Repeal I.R.C. Section 736,” 65 Neb. L. Rev. 450, 453 (1986).

28 MacGillis, supra note 24.

29 Fleischer, supra note 6, at 17.

30 MacGillis, supra note 24.

31 Id.

32 See Jacob Goldstein, “Carried Interest: Why Mitt Romney’s Tax Rate Is 15 Percent,” NPR: Planet Money, Jan. 19, 2012.

33 Quoted in MacGillis, supra note 24.

34 Abrams, supra note 2, at 211-212.

35 Note, supra note 7, at 1775.

36 Id. at 1788.

37 Abrams, supra note 2, at 227.

38 Goldstein, supra note 32.

39 MacGillis, supra note 24.

40 Solman, supra note 3.

41 Renae Merle, “Hillary Clinton’s Plan to Take on This Wall Street Perk May Have a Big Problem,” The Washington Post, June 21, 2016. Determining if the president has that power is beyond the scope of this article and irrelevant given the outcome of the election.

42 Lawrence Delevingne, “CNBC Explains: Carried Interest,” CNBC, Mar. 4, 2014.

43 MacGillis, supra note 24.

44 Section 1221(a)(1).

45 David A. Weisbach, “The Taxation of Carried Interests in Private Equity,” 94 Va. L. Rev. 715, 729 (2008).

46 Id.

47 Mauldin v. Commissioner, 195 F.2d 714 (10th Cir. 1952).

48 Weisbach, supra note 45, at 717.

49 Id.

50 Section 1221(a)(1).

51 Malat v. Riddell, 383 U.S. 569, 572 (1966).

52 Raymond J. Elson and Leonard G. Weld, “Carried Interest: What Is It and How Should It Be Taxed?” CPA J. (Nov. 2007).

53 Section 1221(a)(3) and (5) through (7).

54 IRS Publication 544, “Sales and Other Dispositions of Assets,” at 22 (Feb. 2, 2016).

55 H.R. Rep. No. 83-1337, at A273-A274 (1954).

56 Section 41(b)(2)(C).

57 See Abrams, supra note 2, at 198; Fleischer, supra note 6, at 15; and Weisbach, supra note 45, at 717.

58 Rev. Proc. 93-27; see also Dagres v. Commissioner, 136 T.C. 263, 286 (2011).

59 Dagres, 136 T.C. at 281.

60 Weisbach, supra note 45, at 717.

61 Abrams, supra note 2, at 198.

62 Goldstein, supra note 32.

63 Fleischer, supra note 6, at 11, 14.

64 Id. at 11; Rev. Proc. 93-27.

65 Abrams, supra note 2, at 223.

66 Id.

67 Id.

68 Fleischer, supra note 6, at 13.

69 Fleischer, “An Income Tax on Carried Interest Couldn’t Be Avoided,” The New York Times, July 9, 2015.

70 Committee for a Responsible Federal Budget, “Levin, Baldwin Introduce Bill to Close Carried Interest Loophole” (July 1, 2015).

71 Fleischer, supra note 69.

72 Lee Sheppard, “Trump’s Tax Plan,” Forbes, Nov. 13, 2016.

73 Louis Jacobson and Molly Moorhead, “Effort to Increase Taxes on ‘Carried Interest’ Falls Short Again,” Politifact, Jan. 2, 2013 (mentioning Obama in 2008 pledging to tax carried interest as regular income).

74 Judith Lewis Mernit, “How the Carried-Interest Loophole Makes the Super-Rich Super-Richer,” Bill Moyers, June 23, 2016.

75 Richard Phillips, “What a Trump Administration and Republican Congress Will Likely Mean for Tax Policy,” Tax Justice Blog, Nov. 16, 2016.

76 Chuck Marr and Chye-Ching Huang, “House GOP ‘A Better Way’ Tax Cuts Would Overwhelmingly Benefit Top 1 Percent While Sharply Expanding Deficits,” Center on Budget and Policy Priorities (Sept. 16, 2016).

77 Jim Nunns et al., “An Analysis of the House GOP Tax Plan,” Urban-Brookings Tax Policy Center (Sept. 16, 2016).

78 Marr and Huang, supra note 76.

79 Id.

80 Citizens for Tax Justice, “The Distributional and Revenue Impact of Donald Trump’s Revised Tax Plan” (Sept. 26, 2016).

81 Phillips, supra note 75.

82 Fleischer, supra note 6, at 51.

83 Id. at 53.

84 Id. at 54.

85 Note, supra note 7, at 1795.

86 Fleischer, supra note 6, at 5.

87 Id. at 49.

88 Id. at 50.

89 Toluse Olorunnipa and Angela Greiling Keane, “Obama Renews Carried Interest Tax Fight With Republican Help,” Bloomberg Politics, Sept. 16, 2015.

90 Chris Isidore, “Buffett Says He’s Still Paying Lower Tax Rate Than His Secretary,” CNN Money, Mar. 4, 2013.

91 Phillips, supra note 75.

92 Jason Russell, “Look at How Many Pages Are in the Federal Tax Code,” Washington Examiner, Apr. 15, 2016.

93 Fleischer, supra note 6, at 50.

94 Id. at 51.

95 Id. at 59.

96 Fleischer, “How a Carried Interest Tax Could Raise $180 Billion,” The New York Times, June 5, 2015.

97 CBPP, “Policy Basics: Where Do Federal Tax Revenues Come From?” (Mar. 4, 2016).

98 Patricia Cohen, “What Could Raising Taxes on the 1% Do? Surprising Amounts,” The New York Times, Oct. 16, 2015.