The Taxation of Private Equity Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income

ABSTRACT In this Article, I estimate the tax revenue effects of taxing private equity carried interests as ordinary income rather than as long-term capital gain as under current law. Under reasonable assumptions, I conclude that the expected present value of additional tax collections would be between I percent and 1.5 percent of capital invested in private equity funds, or between $2 billion and $3 billion a year. That estimate, however, makes no allowance for changes in the structure of such funds or the composition of the partnerships, which might substantially reduce tax revenues below those estimates. TABLE OF CONTENTS INTRODUCTION I. THE STRUCTURE OF PRIVATE EQUITY FUNDS II. THE TAXATION OF PRIVATE EQUITY FUNDS III. ESTIMATING THE REVENUE CONSEQUENCES OF TAXING CARRIED INTERESTS AT ORDINARY INCOME TAX RATES IV. CONVERTING THE ESTIMATES FROM PRESENT VALUES INTO DOLLARS A. The Additional Tax Revenue from Changing Both the Character and Timing of Taxation B. The Additional Tax Revenue from Changing Only the Character of Taxation V. CHANGING THE STRUCTURE OF PRIVATE EQUITY FUNDS A. Loans from Limited Partners to the General Partner B. Converting Limited Partners into Creditors C. Transferring Deductions to Portfolio Firms D. Summary VI. CHANGING THE COMPOSITION OF PRIVATE EQUITY PARTNERSHIPS VII. THE JOINT COMMITTEE'S TAX REVENUE ESTIMATE CONCLUSION INTRODUCTION The controversy over the tax treatment of carried interests held by the managers of private equity funds continues. Private equity firms receive a share of the profits--typically 20 percent--earned by the funds they manage. Under current law, the owners of private equity firms are taxed at capital gains rates--generally 15 percent--on those profits. As a result, Warren Buffet and others have noted that the principals of some of the most successful private equity firms pay a smaller share of their income in taxes than do many middle-income Americans. (1) In the summer and fall of 2007, the newspapers were filled with editorials and opinion pieces on the tax treatment of carried interests. Most of these pieces argued that carried interests are compensation for services and should be taxed as ordinary income. (2) Many of these pieces characterized the current tax treatment of carried interests as a massive giveaway. (3) In the summer of 2007, Congress held hearings on the tax treatment of private equity. (4) Except for representatives from the private equity industry, most of the witnesses urged Congress to tax the managers of private equity funds more heavily. (5) Academics are also writing about the tax treatment of private equity. (6) Most academics are urging Congress to tax carried interests as ordinary income. (7) As Victor Fleischer noted in July 2007, there appears to be an emerging consensus among all but the private equity industry itself that the tax treatment of carried interests is unjustifiably low. (8) Yet there are other voices emerging. In addition to those of the private equity industry with its dire predictions of the consequences of taxing carried interests as ordinary income, (9) more measured voices are beginning to see as more complex the tax and economic issues such a change would uncover. (10) The stakes in the debate over carried interests were raised substantially when Representative Charles Rangel (D-N.Y.) linked the tax treatment of carried interests with reform of the alternative minimum tax (AMT). (11) Almost four million taxpayers paid the AMT in 2007. (12) Because it is not indexed for inflation, the AMT would have ensnared an additional 20 million taxpayers that year; each year, however, Congress has voted to index the AMT for the current year. (13) The annual cost of the AMT patch is now roughly $50 billion. (14) Under the pay-as-you-go budgetary rules that Congress adopted in 2007, tax cuts and expenditure increases must be offset with other tax increases. …