The Carried Interest Controversy: Let's Not Get Carried Away

Fueled by significant press scrutiny, the tax treatment of "carried interests" has generated intense controversy in the tax academy and on Capitol Hill. Carried interests are profit shares granted to investment fund managers in exchange for services. Under current law, wealthy fund managers often report the income from the compensatory carried interest at the low 15% capital gains rate. This has provoked the recent outrage since ordinary workers pay tax on their compensation at regular rates as high as 35%. In response, Representative Levin recently proposed a bill which would tax fund managers at the higher 35% rate on all their fund earnings. While this response initially appeals as a matter of basic fairness, we believe that deeper analysis exposes several fatal defects in the Levin Proposal. In contrast to others who critique the Levin proposal, however, we similarly reject the do-nothing status quo. We advocate instead a more moderate legislative fix. Under our approach, the increased tax rate would apply to only a portion of the carried interest return, equal to a fixed rate of interest on the investors' capital subject to the carried interest. As discussed below, this narrowed application has strong theoretic appeal. It also provides a practical middle-ground compromise between the two extremes of the Levin Proposal and the status quo. The carried interest is best analyzed as an implicit loan to the manager since the manager receives the full profits from the invested capital subject to the carried interest. From this perspective, the taxable compensation is limited to the lack of interest on the "loaned" capital. Despite some recognition of its theoretic appeal, no commentator has yet to advocate adoption of the interest charge approach. We believe that several missing pieces to the analysis, including our key modification to the approach, explain its failure to gain traction. In contrast to other commentators, we would grant the manager an interest expense allowance for any foregone interest on the loaned capital. Our adjustment provides desirable consistency with the treatment of an actual interest-free loan. It also avoids an undesirable double taxation of the foregone interest (once as compensation, and a second time upon the fund's actual realization of the carried interest profit). We grant this interest expense allowance in reliance upon an existing, but under appreciated, provision that permits "investment interest" expense to be deducted only against "investment income." This significant limitation insures that the compensation from the carried interest will be taxed at the desired higher rates since it blocks use of the interest expense against the reportable compensation. In sum, our approach makes sound economic sense and favorably treats the implicit carried interest loan the same as an actual interest-free loan. The Levin proposal goes overboard in taxing the carry more harshly than an actual loan. Current law misses the mark in the other direction by taxing the carry more lightly than an explicit loan. Finally, our modified approach also contains other benefits over the Levin Proposal. For instance, the Levin Proposal increases the "tax lock-in" effect over what it is under current law by increasing the tax rate on the managers' realized carry profits. Our proposal favorably avoids this increase by maintaining the low capital gains rate on the realized carry profits.