CBO

TESTIMONY

Statement of

Peter R. Orszag

Director

The Taxation of Carried Interest

before the

Committee on Finance

United States Senate

July 11, 2007

CONGRESSIONAL BUDGET OFFICE

SECOND AND D STREETS, S.W.

WASHINGTON, D.C. 20515

This document is embargoed until it is delivered at

10:00 a.m. (EDT) on Wednesday, July 11, 2007.

The contents may not be published, transmitted, or

otherwise communicated by any print, broadcast,

or electronic media before that time.

Chairman Baucus, Senator Grassley, and Members of the Committee, thank you

for inviting me to testify on the taxation of carried interest.

My testimony makes the following main points:

B A growing amount of financial intermediation is occurring through private

equity and hedge funds, which are typically organized as partnerships or limited

liability companies and now have at least $2 trillion under management. Those

organizational forms are growing rapidly for many reasons, including their tax

advantages over traditional financial services corporations.

B A general partner of a private equity or hedge fund typically receives two types

of compensation: a management fee tied to some percentage of assets under

management and “carried interest” tied to some percentage of the profits generated by those assets. The management fee is taxed as ordinary income to the

general partner. Taxation on the carried interest is deferred until profits are realized on the fund’s underlying assets, and any resulting profits to the general

partner are taxed at the capital gains tax rate to the extent the fund’s profits

reflect capital gains.

B Most economists, however, would view at least part and perhaps all of the carried interest as performance-based compensation for management services provided by the general partner rather than a return on financial capital invested by

that partner. That perspective would suggest taxing at least some component of

the carried interest as ordinary income, as most other performance-based compensation is currently treated, regardless of the nature of the underlying investments generating the profits of the fund.

B A variety of proposals have been put forward to alter the tax treatment of carried interest. Policymakers considering those changes need to evaluate many

factors, including the potential distortions created by the current tax treatment

of partnerships and carried interest relative to that of other organizational forms

and types of income; the consequences for a broad range of industries, including real estate development, if a general solution is adopted, or the advisability

of industry-specific rules, if a solution targeted to financial investment funds is

pursued; the potential unintended effects, complexity, and perceived fairness of

tax changes; and any net revenue effects. My testimony briefly reviews several

recent proposals to change the tax treatment of carried interest in light of those

considerations.

B Much of the complexity associated with the taxation of carried interest arises

because of the differential between the capital gains tax rate and the ordinary

income tax rate, which creates an incentive to shift income into a form classified as capital gains. Further widening of the differential between the taxation

of ordinary income and of capital gains would create even stronger incentives to

shift income into the tax-preferred capital form.
2

I would also emphasize that any revenue estimates associated with changing the

tax treatment of carried interest would be undertaken by the Joint Committee on

Taxation. My testimony therefore does not discuss specific revenue effects from

proposed changes to that tax treatment.

Recent Innovations in Financial Services

Financial markets have experienced substantial innovation over the past several

decades. Those innovations have affected the assessment and pricing of risk

(including the development of credit derivatives and interest rate swaps) and the

use of financial markets in supplying credit. The resultant changes in the allocation

of capital and the pricing and dispersion of risk has probably contributed to continued economic growth. By increasing businesses’ and households’ access to capital, financial innovations probably also help explain the dampening of business

cycles and the significant decrease in macroeconomic volatility over the past two

decades.1 The innovations also, however, have facilitated an ability by individual

market participants to assume substantially greater degrees of risk and thus raised

concerns about potential systemic risks to the financial system.

In addition to their effects on the allocation of capital and dispersion of risk, the

financial innovations have been associated with substantial rewards to many people engaged in financial activities. The compensation of the top executives of

investment banking firms are among the highest in the country. Recently, the pay

of those top executives has, if anything, been surpassed by the compensation of

people managing investments through alternative structures such as private equity

and hedge funds. A recent study estimated that in 2004, almost nine times as many

of those types of investors earned in excess of $100 million as did public company

chief executive officers.2 According to one press account, the top 25 hedge fund

managers earned $14 billion in 2006, with one manager earning more than

$1.5 billion. The substantial income accruing to managers of private equity and

hedge funds is one facet of and a contributor to broader income trends.

Private equity and hedge funds in particular have played an increasingly important

role as financial intermediaries:

1. See Karen E. Dynan, Douglas W. Elmendorf, and Daniel E. Sichel, Can Financial Innovation

Help to Explain the Reduced Volatility of Economic Activity? Finance and Economics

Discussion Series, Working Paper No. 2005-54 (Washington, D.C.: Federal Reserve Board,

November 2005). The decline in macroeconomic volatility, however, does not appear to have

been associated with a reduction in the volatility of household earnings or income. See

Statement of Peter R. Orszag, Director, Congressional Budget Office, Economic Volatility,

before the Joint Economic Committee (February 28, 2007).

2. See Steven N. Kaplan and Joshua Rauh, Wall Street and Main Street: What Contributes to the

Rise in the Highest Incomes? Working Paper No. 615 (Chicago, Ill.: University of Chicago,

Graduate School of Business, Center for Research in Security Prices, September 13, 2006).
3

B Private equity funds raise capital to purchase or invest in new and existing businesses. They are private in the sense that their ownership interests are not publicly traded. Instead, they raise investment capital outside public financial

markets from sources such as pension funds, endowments and foundations, and

wealthy individuals. With those funds, they make various investments, including in publicly traded companies. Private equity firms may acquire mature public companies with the intent of converting them to private companies,

restructuring or reorganizing their activities, and then later reselling them to the

public or another firm. The initial purchase of a public firm by the private

equity fund can be done through a leveraged buyout (LBO), in which the private equity firm relies heavily on debt raised from third-party investors to

finance the necessary purchases of the public company’s shares. Venture capital

is a type of private equity that specializes in investing in small start-up businesses.

B Hedge funds trade in a variety of financial markets and typically adopt complicated investment strategies, often involving financial derivatives. Some funds

buy and sell stocks of publicly traded companies or derivative instruments

based on stocks, such as options. Some specialize in debt instruments based on

corporate loans, mortgages, and credit card debt. Many derivatives of subprime

mortgages are held in hedge funds. Other hedge funds specialize in trading currencies, commodities, and derivatives based on them. Despite their name, hedge

funds are not necessarily “hedged” in the traditional sense of being insulated

from risk; many hedge funds take significant risks either knowingly or unknowingly. As with private equity funds, hedge funds do not raise funds through public issuance of securities; instead, they typically raise capital from institutions

and wealthy individuals. Hedge funds’ investments are often intended to be

shorter term and typically do not involve management control, in contrast to the

investments made by private equity funds, although the distinction between

hedge funds and private equity can become blurred in practice.

The role of private equity and hedge funds has expanded substantially in the past

20 years. From 1980 to 1995, the amount of capital under management in the private equity market increased from roughly $5 billion to over $175 billion.3 In the

past decade, the market has continued to experience rapid growth, and by some

estimates, private equity funds now have more than $1 trillion under management.

Estimates also suggest that roughly 8,000 to 9,000 hedge funds now exist, with

more than $1 trillion in funds under management. In other words, private equity

funds and hedge funds together have more than $2 trillion under management.

In 2006, private equity firms raised over $240 billion in capital, up from less than

$25 billion a year in the early 1990s (see Figure 1). The private equity market is

3. See Stephen D. Prowse, “The Economics of the Private Equity Market,” Economic and Financial Policy Review, Federal Reserve Bank of Dallas, Third Quarter (1998), pp. 21–34.
4

Figure 1.

Capital Raised by U.S. Private Equity Funds

(Billions of dollars)

Source: Congressional Budget Office based on data from Thomson Financial, Morgan Stanley 

Research.

dominated by a small number of major players. Over the past five years, the top

five private equity firms have raised an average of $30 billion in capital. The average amount raised among the next five largest firms was $18 billion and among

the next 40 largest firms, about $8 billion.

The volume of private equity deals more than doubled in 2006, with LBOs

accounting for almost 20 percent of the $3.5 trillion in global mergers and acquisitions. This year, LBOs accounted for more than 17 percent of the $2.26 trillion in

deals through June 2007 and are on pace to break last year's record volume.4

Tax data provide another indication of the significant income that flows through

entities such as private equity and hedge funds, along with other partnerships and

S corporations. In 2005, capital gains from partnerships and S corporations were

22 percent of total current-year long-term capital gains reported on individual

income tax returns, and 27 percent of the gains received by the 1 percent of taxpayers with the highest income (those figures do not include losses carried over

from previous years).

4. Thomson Financial, as cited in “Who’s Who in Private Equity,” The Wall Street Journal Online,

available at www.wsj.com.

1990 1992 1994 1996 1998 2000 2002 2004 2006

0

50

100

150

200

250

Buyout Funds

Venture Funds

Other Private Equity
5

Structure and Tax Treatment of Private Equity and

Hedge Funds

Most private equity and hedge funds are organized as partnerships or limited liability companies; in most of this testimony, they are referred to simply as partnerships, because the tax characteristics of partnerships and most limited liability

companies are essentially identical.

The partnerships typically consist of one or more general partners, who manage

the partnership and determine the investment strategy, and limited partners, who

contribute capital to the partnership but do not participate in management. General

partners may also invest their own financial capital in the partnership, but such

investments usually represent a small share of the total funds invested. (The general partner is itself typically a partnership, with the individual managers of the

fund as partners.)

Several factors may motivate private equity and hedge funds to be organized as

partnerships. For example, a partnership structure is often attractive because its

flexibility can accommodate complex financial arrangements among those managing the fund and those contributing capital to it. It is likely, however, that tax law

plays an important role in explaining why so much financial management activity

is now occurring through partnerships. In particular, private partnerships (and limited liability companies electing to be treated as a partnership for tax purposes) do

not pay a separate corporate income tax. Instead, they pass all income and losses

through to the partners, who are liable for any income tax. As described below, the

partnership structure is also attractive to investment fund managers because of the

manner in which part of their compensation (the so-called carried interest) is

taxed.

In contrast to private partnerships, publicly traded partnerships are generally

treated as corporations for tax purposes and are subject to the corporate income

tax. (The primary exception to this rule is that certain partnerships that derive at

least 90 percent of their income from passive investments such as dividends, interest, rents, and capital gains or from mining and natural resources and that are

therefore not required to register as investment companies under the Investment

Company Act of 1940 do not pay the corporate tax.)

The taxation of the partnership entity itself is not the primary focus of my testimony, although it is worth noting that corporate income tax revenues have

declined over the past several decades relative to the size of the economy, partly

because of the effects of financial innovation and global integration and possibly

because of the increased use of noncorporate forms of conducting business (which

were created in part to avoid the potential distortions associated with corporate
6

taxation).5 Developments such as the growth of private equity and hedge funds

may affect corporate income tax revenues in the future; a number of private equity

firms, for example, are taking steps to go public without relinquishing their

exemption from the corporate tax. Legislation introduced by Chairman Baucus

and Ranking Member Grassley would tax as corporations publicly traded partnerships that derive income from asset management or as investment advisers.

Carried Interest

A general partner in a private equity or hedge fund is typically compensated in two

ways: through a fixed management fee and a share of profits.

The fixed management fee, usually 1 to 2 percent of the assets under management,

does not depend on the performance of the fund. For example, if the fund had

$1 billion in assets under management and a 2 percent management fee, the management fee would amount to $20 million a year, and that amount would not

depend on the return on the $1 billion in assets. The $20 million would be taxed as

ordinary income to the general partner and would generate a deduction as an

investment expense for the limited partners.

The second component of the general partner’s compensation is a share of the

profits on the assets under management. That component, which is often 20 percent of such profits, is usually referred to as carried interest, or, simply, carry.6 For

example, assume the fund with $1 billion in assets generated a 15 percent realized

profit in a year. Of the $150 million in profits, the general partner earning 20 percent carried interest would receive $30 million. The other $120 million in profits

would be split among the investors in the fund (including the general partner if he

or she owned some of the capital in the fund in addition to managing it). In many

cases, the general partner earns carried interest only when profits exceed some

threshold.7 For example, in many private equity funds, the general partner will

5. Corporate tax revenues declined from 3.6 percent of gross domestic product (GDP) in 1962 to

1.2 percent in 2003. A recent surge in corporate tax collections has temporarily reversed that

longer-term trend—corporate tax revenues rose from 1.2 percent of GDP in 2003 to 2.7 percent

in 2006, explaining the bulk of the overall increase in federal revenues over that time—but

CBO projects a gradual decline in that share from current levels. See Congressional Budget

Office, Federal Tax Revenues from 2003 to 2006 (May 18, 2007) and The Budget and Economic Outlook: Fiscal Years 2008 to 2017 (January 2007).

6. Managers of public mutual funds are not permitted to be paid in that fashion. Because private

equity and hedge funds are exempt from the Investment Company Act of 1940, however, that

form of compensation is permitted.

7. Such a preferred return for the limited partners is more common in private equity buyout firms

than in venture capital firms. See Victor Fleischer, “The Missing Preferred Return,” UCLA

School of Law Research Paper No. 05-8 (February 2005).
7

receive carried interest only when profits exceed a “hurdle rate,” often an 8 percent

return.8

Tax Issues Surrounding Carried Interest

Carried interest arrangements for partnerships raise two significant tax issues: the

timing and the character of the income earned by the general partner. Both of those

issues involve the same underlying question, which is whether a general partner’s

carried interest should be treated as a quasi-investment in the partnership by the

general partner, with the result that the carried interest would be subject to the

same tax rules as apply to the limited partners’ partnership interests, or whether the

general partner’s carried interest is more properly viewed as some form of contractual undertaking by the limited partners (or the partnership) to compensate the

general partner for management services.

Deferral of Taxation

The first tax issue involves the timing of a general partner’s tax liability for the

carried interest that he or she receives for managing the fund. Under current law

and regulations, carried interest is not taxed at the time the right to the future profits is granted (for example, when the partnership is created) but rather when the

partnership realizes profits that are allocated to the general partner.

At one level, deferral is a specific example of a more pervasive phenomenon,

which is the tax code’s reliance on realization events—the sale of an investment,

for example—to determine the timing of income from investments. Indeed, limited partners in a private equity fund also enjoy the benefits of deferral: They do

not pay tax on unrealized gains but only on gains that have been recognized

through a sale or similar event.

At another level, however, deferral as applied to a general partner’s carried interest

effectively assumes the conclusion of the underlying technical and policy issue:

whether the general partner’s carried interest should be treated as a simple investment by the general partner (albeit one that has no claim to the current capital of

the fund but only to the future appreciation thereof), or whether, at least to some

degree, the carried interest in substance is a form of compensation paid by the limited partners to the general partner for services in managing the fund. Most analysts believe that alternative characterization is more accurate.

8. If that 8 percent hurdle rate applied to the example, the general partner would receive the 20

percent carried interest on $70 million (which is the $150 million in profits minus the threshold

of $80 million that must be exceeded before carried interest applied), or $14 million.
8

More specifically, carried interest can be viewed as a call option on a limited partnership interest, with a value equal to 20 percent of the future capital in the fund

and a strike price equal to 20 percent of the initial value of the fund.9 Options pricing formulas, such as the Black-Scholes formula, can then be applied to valuing

the carried interest. Although various complications arise in applying such options

pricing techniques (including the requirement to estimate both the duration of the

fund and the volatility of the underlying investments), it is clear that whatever the

imperfections in the valuation process, an interest in future profits has some value

greater than zero.

It is worth noting that deferral of taxation on carried interest generates a tax benefit

to the general partner (who does not recognize income initially) but a tax cost to

the limited partners (who do not enjoy a deduction or other reduction in taxable

income at that point). Many limited partners are either tax-exempt entities in the

United States or foreign institutions (see Table 1), however, so they may be largely

unaffected by the lack of an immediate U.S. tax benefit. The net result is, therefore, the overall deferral of a net tax liability.

Treatment as Capital Gains or Ordinary Income

The second issue is the character of the income received as carried interest. Under

current law and regulations, carried interest is treated in the same way as all other

profits from the partnership for tax purposes. In particular, carried interest flows

through to the general partner on the basis of the nature of the income from the

underlying investments. Thus, if the carried interest arises from realizations of

long-term capital gains on the investments held by the fund, the general partner is

taxed on the carried interest at the long-term capital gains rate. In the paradigmatic

private equity case, most profits arise from long-term capital gains, so the profit

allocated to the general partner’s carried interest will be taxed as long-term capital

gains.10 For simplicity, the remainder of this testimony assumes that case and also

assumes that no hurdle rate is applied to the carried interest. Such a hurdle rate

would affect the precise examples and calculations but not the underlying substance of the issue.

9. A call option gives the holder the right to purchase an asset at the strike price. Consider a fund

with $1 billion under management and 20 percent carried interest. If the fund then grows in the

future to $1.5 billion, the general partner will be entitled to 20 percent of the $500 million

increase, or $100 million. That outcome is equivalent to a right to receive 20 percent of the

future value of the fund ($1.5 billion x 20 percent = $300 million) in exchange for paying 20

percent of the initial value of the fund ($1 billion x 20 percent = $200 million). This example

assumes no hurdle rate is applied to the carried interest; the presence of such a hurdle rate

would be reflected in the valuation of the option.

10. A hedge fund’s income from securities trading, by comparison, usually constitutes a short-term

capital gain or ordinary income, particularly if, as often is the case, the fund has elected to be

taxed as a securities trader under section 475(f) of the Internal Revenue Code.
9

Table 1.

Percentage of Capital Investment in Private Equity by

Type of Limited Partner

Source: Private Equity Council, Public Value: A Primer on Private Equity (Washington, D.C., 2007), 

p. 11.

a. Based on a sample of more than 75 global funds with total capital of over $32 billion.

b. Based on a sample of more than 110 global funds with total capital of over $44 billion.

To see how that system of taxation works, assume that a fund realized a profit of

$150 million in long-term capital gains and that the carry was equal to 20 percent

of that profit, or $30 million. The general partner would then pay capital gains tax

on that $30 million; at a capital gains tax rate of 15 percent, the tax owed would be

$4.5 million.

As an economic matter, the character of carried interest income should not depend

on whether the compensation is performance-based. A wide range of performancebased compensation, including arrangements in which service providers accept the

entirety of the risk of the success or failure of the enterprise, is effectively labor

income and taxed as ordinary income for services. Contingent fees based on movie

revenue for actors, for example, are taxed as ordinary income, as are performance

bonuses, most stock options, and restricted stock grants.11 So too are incentive

fees paid to managers of other people’s investment assets, when those fees are documented as such rather than as carried interest in a formal partnership. Instead, the

key issue is whether the carried interest represents a fee for services provided or a

11. The tax treatment of nonqualified stock options, which are the most common type of options, is

an example. Nonqualified stock options are generally taxed when they are exercised (although

the tax can be delayed if the purchased shares are subject to a substantial risk of forfeiture), and

the difference between the market price at the time of exercise and the strike price (multiplied

by the number of shares) is taxed as ordinary income. The tax treatment of incentive stock

options is more advantageous, but current law significantly limits the value of such options that

can receive favorable tax treatment.

Public Pension Funds 22 26.6

Corporate Pension Funds 10 12.3

Union Pension Funds 1 1.4

Banks and Financial Services 6 9.8

Insurance Companies 12 7.5

Endowments/Foundations 10 7.7

Family Offices 11 6.8

Wealthy Individuals 10 10.1

Funds of Funds 13 13.9

Other 5 3.9 ____ ____

Total 100 100

2005a 2006b
10

return of partnership long-term capital gains allocated to one partner (the general

partner) under conditions that are not qualitatively different from the returns allocated to the other partners (the limited partners).

Most legal and economic analysis suggests that carried interest represents, at least

in part, a form of performance-based compensation for services undertaken by the

general partner. Although individual analyses differ slightly, there are two important themes with which most analysts concur. First, a general partner in a private

equity or hedge fund undertakes a fundamentally different economic role from that

of the limited partners, because the general partner is responsible (by virtue of his

or her expertise, contacts and experience, and talent) for managing the fund’s

assets on a day-to-day basis. Second, the carried interest is not principally based

on a return to the general partner’s own financial assets at risk. If the purpose of

the preferential rate on long-term capital gains is to encourage investors to put

financial capital at risk, there is little reason for that preference to be made available to a general partner, whose risk involves his or her time and effort rather than

financial capital.

Some observers view carried interest as a mixture of compensation for management services and capital returns. For example, one can think of carried interest as

an interest-free nonrecourse loan from the limited partners to the general partner

equal to 20 percent of the partnership assets, with the requirement that the loan

proceeds be reinvested in the fund. (A borrower is not personally liable for a nonrecourse loan, beyond the pledged collateral, which in this case is the general partner’s claim on future profits.) To see how this example works, imagine a fund

worth $100 million. With no direct capital investment, the carried interest entitles

the general partner to the profits on $20 million (20 percent of the profits on $100

million is equivalent to the full profits on $20 million). It is therefore as if the limited partners have contributed $80 million to the fund and then lent the general

partner $20 million to invest in the fund too, but without charging the general partner interest on that loan.

This implicit loan perspective would result in treating carried interest somewhere

between purely capital income and purely ordinary income. In particular, under

current tax rules, the implicit interest on an interest-free loan would be taxed as

ordinary income, with the interest rate set at the current rate on federal securities

with the same duration as the loan. At the time the partnership sold its assets, any

gain or loss to the general partner, after paying back the loan, would be treated as

capital. In effect, then, this perspective would suggest that the component of carried interest attributable to implicit interest on the implied loan would be ordinary

income and that the returns in excess of that implicit interest would be capital

income.12

12. The presence of a hurdle rate on the carried interest would affect the calculation of the forgone

interest on the implicit loan provided to the general partner.
11

The differential tax treatment of carried interest relative to the management fees

earned by general partners has apparently led to efforts to transform management

fees into carried interest. Consider the example of the $1 billion investment fund

with a 2 percent management fee, 20 percent carried interest, and a 15 percent

realized profit on long-term capital gains. The general partner would then receive

$50 million in income: $20 million in management fees and $30 million in carried

interest. With a 35 percent ordinary income tax rate and a 15 percent long-term

capital gains tax rate, the general partner would pay $11.5 million in income taxes.

If the general partner was able to reduce the management fee to 1 percent and

increase the carried interest to 26.7 percent, the income flowing to the general

partner would remain $50 million ($10 million in management fees and $40 million in carried interest). The taxes owed, however, would decline by $2 million, to

$9.5 million. Such transformations of management fees into carried interest have

apparently occurred, in some cases even after realized profits are known. Those

types of transformations further highlight some of the similarities and, therefore,

the interchangeability between management fees and carried interest. That those

components of compensation are substituted for each other suggests, at least in

part, that both types of income represent compensation to the general partner for

management of the fund.

Finally, the issues of characterizing a flow of income as a return on capital or compensation for services provided are not unique to private equity or hedge fund partners and are not new developments. Many real estate development deals, for

example, are structured as partnerships with essentially similar characteristics, in

which an active manager or developer obtains a disproportionate share of partnership income or profits in return for his or her contributions of intangibles (contacts,

know-how, and so forth) and management of the project. Nonetheless, the typical

private equity firm presents the paradigmatic case for considering the appropriate

tax treatment of carried interests.

Options for Modifying the Tax Treatment of

Carried Interest

The tax issues described in the previous section have given rise to proposals to

change the current tax treatment of carried interest. Policymakers considering such

proposals may want to weigh the underlying substance of the tax issue at hand

with various other considerations. For example, in general, changes in tax policy

that have significant and potentially unexpected effects on particular industries

should be approached with caution, because a broader policy objective may be

served by stability and an associated perception of fairness. Furthermore, as noted

above, carried interest arises not just within private equity and hedge funds; it is

also a common feature of partnerships in other sectors. Many of the underlying tax

issues that arise with regard to the taxation of carried interest in the financial services sector arise in those other sectors as well, and policymakers interested in

changing the tax treatment of carried interest therefore need to evaluate the costs
12

and benefits of changing that treatment for all carried interest relative to restricting

the change to the financial services industry.

Several proposals have been put forward to modify the tax treatment of carried

interest. Under these proposals, some, if not all, carried interest would be treated

as ordinary income regardless of the type of asset generating the fund’s profits.13

Tax Carried Interest as Property When Granted. One alternative would be to

tax the general partner on carried interest when granted. Under section 83 of the

Internal Revenue Code, property (other than an option) transferred to a person in

connection with the performance of services is generally taxed when that property

is transferred. Under relatively unusual facts, the tax court held in Diamond v.

Commissioner that the grant of a carried interest right “with determinable market

value” constituted current ordinary income to the general partner.14 Because carried interest may be difficult to value, though, most practitioners continued to view

the granting of carried interest as a nontaxable event. The Internal Revenue Service later embodied that view in Revenue Procedure 93-27. One possibility would

be to alter that revenue procedure and apply section 83 to the grant of a carried

interest. The valuation could then be done by Black-Scholes or some other

method.15 The grant would be currently taxable as ordinary income to the general

partner and generate a deduction for the limited partners.16

This approach would affect both the deferral component of carried interest and its

character. For the reasons described above regarding the limited impact from a

deduction granted to the limited partners, the result would be a net acceleration of

revenues received by the federal government. Another result would be that the carried interest (its value determined at the time it was granted) would be treated as

ordinary income. To the extent that the carried interest then appreciated or depreciated in value relative to the initial estimate, the changes would be taxed as capital

gains or losses.

This approach would require some acceptable valuation methodology, however,

which might be difficult to apply in the wide variety of circumstances in which

carried interest arises. Furthermore, even with an accepted valuation methodology,

modest changes in the assumptions applied may generate significant changes in

13. To implement any of these options, policymakers would also need to decide whether to treat the

resultant ordinary income as labor income; if so, the income would also generally be subject to

payroll taxation. The arguments in favor of viewing carried interest as ordinary income would

tend to suggest that tax treatment.

14. Diamond v. Commissioner, 56 T.C. 530, (1971), (aff’d), 492 F. 2d 286 (7th Cir. 1974).

15. See, for example, Lee A. Sheppard, “Blackstone Proves Carried Interests Can Be Valued,” Tax

Notes, vol. 115, no. 13 (June 25, 2007), pp. 1236–1243.

16. Although the valuation of the grant may be undertaken using options pricing methodologies,

this tax treatment would differ from that applied to nonqualified stock options, which are typically not taxed when they are granted but when they are exercised.
13

valuation—creating opportunities to understate the value of the carried interest

when granted. Finally, as noted above, deferral arises in a variety of settings across

the tax code, and some observers believe eliminating deferral in this context but

not others would not be justified.17

Tax Carried Interest as Ordinary Income When Realized. A second option

would be to continue to allow deferral but to view carried interest as a fee for services provided and therefore tax the income distributed to the general partner as

ordinary income. Carried interest would thus be taxable to the general partner as

ordinary income and deductible as an expense incurred to earn investment income

to the limited partners. As an example of this broad approach, consider the fund

with $1 billion in assets and 20 percent carried interest. If the fund earned a realized profit of 50 percent, the carried interest of $100 million would be taxed to the

general partner as ordinary income (rather than capital gains). At a 35 percent tax

rate, the income tax owed would be $35 million, rather than the $15 million that

would be due if the income were taxed at the 15 percent capital gains tax rate.18

H.R. 2834, introduced by Representative Levin and others, would implement this

approach. Another approach proposed to accomplish the same objective is to modify section 707(a)(2)(A) of the Internal Revenue Code to require that carried interest be treated as a transaction between the partnership and a nonpartner; the result

would be to treat the carried interest as ordinary income.19

This approach would most closely mirror the tax treatment of nonqualified corporate stock options, which share many characteristics with carried interest. As with

the tax treatment of nonqualified options, this approach would not eliminate the

deferral of taxation (because it would not impose the tax when the carried interest

17. For example, carried interest in the partnership context has much in common with employee

stock options that a corporation might grant to valued employees. The tax code typically taxes

those options as ordinary income only on exercise, in an amount equal to an employee’s economic gain at that time (that is, the difference between the corporate stock’s fair market value

on the exercise date and the price paid by the employee under the terms of the option). Policymakers may want to consider whether it is appropriate to create a timing rule for carried interest

that would vary significantly from the general rule adopted for somewhat analogous nonqualified employee stock options.

18. Again, the limited partners would receive an ordinary income tax deduction, but the net effect

would probably be a revenue gain for the reasons described earlier in the text.

19. See Lee A. Sheppard, “The Unbearable Lightness of the Carried Interest Bill,” Tax Notes,

vol. 116, no. 2 (July 12, 2007), pp. 15–21.
14

was granted) but it would impose ordinary income taxation.20 This approach

would also most directly reflect the view that carried interest fully represents

performance-based compensation for services provided.

The approach might, however, create various tax planning opportunities, including

the use of nonrecourse loans from the limited partners to the general partner, to

attenuate its impact. Finally, although there is widespread agreement among analysts that at least some component of carried interest represents compensation for

services provided, there is somewhat less agreement that the full amount of carried

interest represents such compensation. To the extent that at least some component

of carried interest is viewed as a return on capital invested, this approach could be

viewed as overtaxing carried interest.

Tax Imputed Interest on the Implied Loan.21 A third option would be to explicitly treat the general partner’s carried interest as a nonrecourse loan from the limited partners and tax the value of the implicit interest to the general partner as it

accrued. As a result, that part of the carried interest would be treated as ordinary

income, and part would be treated as a return on capital.

Consider again a private equity or hedge fund partnership that starts with $1 billion in assets. The underlying assets are sold after three years for $1.5 billion, generating a realized profit of $500 million. With 20 percent carried interest, the general partner would receive $100 million when the fund liquidated or sold the assets

(20 percent of the $500 million profit). Under current law, the general partner

would pay a tax of $15 million on his or her share of the profits (15 percent of

$100 million), under an assumption that the distributions qualified as long-term

capital gains. If the carried interest was treated as ordinary income, as in the option

above, the general partner would pay a tax of $35 million (35 percent of $100 million).

If, instead, the 20 percent carried interest was treated as a nonrecourse interest-free

loan with the loan proceeds invested in the fund, the general partner would generally pay a higher tax than under current law but generally less than under the ordinary income option. In particular, in the example, the general partner would be

treated as if he or she had received a $200 million loan from the limited partners,

which he or she then invested in the fund, obtaining a 20 percent interest in the

fund. After three years, the general partner would be treated as if he or she

20. Apparently because of concerns about valuation, nonqualified stock options are generally not

taxed when they are granted, but rather when they are exercised. Such valuation concerns are

similar to those surrounding the value of a carried interest when granted, and the typical deferral of taxation on nonqualified stock options until they are exercised may suggest that the taxation of carried interests should also be deferred, as this option would entail.

21. One analyst describes this option as a cost-of-capital approach. See Victor Fleischer, “Two and

Twenty: Taxing Partnership Profits in Private Equity Funds,” University of Colorado Legal

Studies Research Paper Series, Working Paper No. 06-27 (June 12, 2007).
15

received a 20 percent share of the $1.5 billion in assets held by the fund, or $300

million, and paid back the $200 million loan. The general partner would thus have

a realized gain of $100 million (the underlying carried interest). The tax on that

$100 million would be $15 million, again under the assumption that the fund’s

profits qualified as long-term capital gains. However, because the loan from the

limited partners was interest-free, the general partner would be required by current

law to count the forgone interest payments as ordinary income and pay tax on

them each year.22 With a 5 percent interest rate, the implied ordinary income

would be $10 million per year, and the tax would be $3.5 million per year.23 The

time value of money aside, the total tax bill would be $25.5 million ($15 million

plus $10.5 million). That tax liability, as expected, falls between the tax liability of

$15 million under full capital gains tax treatment and the $35 million under full

ordinary income tax treatment.

One advantage of this approach is that it may be more resistant to financial planning that does not change the underlying economics of the partnership arrangement. It also reflects the view that some analysts hold that carried interest is neither entirely a return on capital nor entirely labor compensation. However, the

approach is clearly complex. The extent of the complexities involved may make

this approach particularly difficult to implement in practice.

A Broader Issue: Differential Tax Rates on

Capital and Labor Income

Much of the complexity associated with the taxation of carried interest arises

because of the differential between the capital gains tax rate and the ordinary

income tax rate. In particular, ordinary income for high-income taxpayers is typically subject to a 35 percent marginal income tax rate and, in the case of labor

income, an additional 2.9 percent payroll tax for Medicare. Long-term capital

gains for such taxpayers are typically subject to a 15 percent tax rate. The difference creates a strong incentive to shift income into forms classified as capital

gains. Whether carried interest represented compensation for services provided or

a return on capital invested would be largely irrelevant if the tax rates on labor and

capital income were the same (although the issue of deferral would still remain).

22. This option assumes that the general partner would not receive a deduction for the imputed

interest payments on the implicit loan. Under current law, imputed interest on actual loans may

generate a deduction for the borrower. Advocates of this option, however, would not extend

such a deduction to the general partner (the borrower of the implicit loan); they justify such a

deduction in different ways.

23. The example follows the convention of using the federal interest rate on short-term securities.

The choice of the proper interest rate is a significant issue in this approach, however. A 5 percent interest rate is arguably too low for a nonrecourse loan on a risky asset. The presence of a

hurdle rate on the carried interest would also affect the calculation of implicit interest.
16

The Tax Reform Act of 1986 set the tax rate on capital gains at the same rate as the

tax on ordinary income, but legislation since then has reintroduced differential tax

treatment. A lower tax rate on capital gains and dividends than on other forms of

income creates opportunities for tax avoidance and complicates the tax system.

Income from sole proprietorships, S corporations, and other noncorporate entities

is a mix of returns to capital and returns to labor, and a significant portion of the

tax code is devoted to attempting to distinguish one type of income from another.

As the tax rate differential increases, the distinctions among different types of

income assume greater importance. Proposals to reduce the tax on capital income

(for example, by moving to a consumption tax) or to raise the tax on labor income

(for example, by increasing the payroll tax) would increase the differential further

and thereby create an even stronger incentive to shift income into a form classified

as capital.

One motivation for differential tax treatment has been a desire to promote capital

formation and economic activity. The empirical evidence suggests, however, that a

low capital gains tax rate has only modest effects on such outcomes. Furthermore,

the application of that broader motivation to carried interest in investment funds is

unclear, because the financial capital that is gathered and invested in such funds is

provided almost entirely by the limited partners, not the general partner.

Many considerations need to be taken into account in evaluating the appropriate

tax rate on capital income. The income-shifting incentives and potential associated

distortions created by differential rates on capital and income, which are highlighted by the debate over carried interest, represent one consideration.