The Taxation of Carried Interests in Private Equity

This essay analyzes the tax treatment of carried interests in private equity. It argues that there are two competing analogies: service income and investment income. Standard approaches are not able to resolve which of the competing analogies is better and often fail even to recognize that there are competing analogies. The best method for determining the proper treatment of carried interests is through direct examination of the effects of each of the possible treatments, known as the theory of line drawing in the tax law. From this approach, it is clear that the better treatment of holders of carried interests is as investors. Key pieces of evidence include the longstanding policy premises behind partnership taxation and the complexity and avoidance problems with attempts to tax carried interests as service income. Send comments to: d‐weisbach@uchicago.edu Walter J. Blum Professor and Kearney Director, Program in Law and Economics, The University of Chicago Law School. This research originated with work funded by the Private Equity Council, published at 116 Tax Notes 505 (August 6, 2007). The two most prominent articles on the topic are Mark Gergen, Reforming Subchapter K: Compensating Service Partners, 48 TAX L. REV. 69 (1992) [Service Partners] and Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, forthcoming, NYU L. REV. (2008) [Two and Twenty]. There have been four congressional hearings on the topic. Carried Interest Part I: Hearing Before the S. Comm. on Finance, 110 Cong. 2007; Carried Interest Part I: Hearing Before the S. Comm. on Finance, 110 Cong. 2007; Carried Interest Part III: Hearing Before the S. Comm. on Finance, 110 Cong. 2007; Hearing on Fair and Equitable Tax Policy for America’s Working Families Before the H. Comm. on Ways and Means, 100 Cong. 2007. Legislation has been introduced on a number of aspects of the issue including H.R. 2834, 100 Cong. 2007 (the Levin bill) and S. 1624, 100 Cong. 2007 (the Baucus Grassley bill). See Joint Committee on Taxation, Present Law and Analysis Relating to the Tax Treatment of Partnership Carried Interests and Related Issues, Part I (JCX‐62‐07), September 4, 2007; Joint Committee on Taxation, Present Law and Analysis Relating to the Tax Treatment of Partnership Carried Interests and Related Issues, Part II (JCX‐63‐07), September 4, 2007 for descriptions of the bills. The Taxation of Carried Interests In Private Equity David A. Weisbach October 9, 2007 A carried interest in a private equity fund typically gives the sponsor of the fund the right to 20 percent of the profits. If the fund produces long‐ term capital gain, the sponsor is taxed on this gain at the capital gains tax rate when the gain is realized. The same treatment applies to a carried interest, also known as a profits interest, in any type of partnership: the holder is a partner and is taxed on his distributive share of partnership income. A number of commentators have argued that returns to carried interests should be taxed as ordinary compensation income, and these claims have prompted close scrutiny from Congress. The theory is that the sponsor performs services for the partnership in exchange for the carried interest. The sponsor is analogized to a money manager who determines how best to invest a client’s funds. They argue, therefore, the carried interest should be taxed similarly to risky returns given to other service providers, such as stock, stock options, or royalties. In particular, the treatment of a carried interest is better than the treatment of other types of risky compensation