Two and Twenty: Taxing Partnership Profits in Private Equity Funds

Abstract:     
Private equity fund managers take a share of the profits of the partnership as the equity portion of their compensation. The tax rules for compensating service partners create a planning opportunity for managers who receive the industry-standard "two and twenty" (a two percent management fee and twenty percent profits interest). By taking a portion of their pay in the form of partnership profits, fund managers defer income derived from their labor efforts and convert it from ordinary income into long-term capital gain. This quirk in the tax law allows some of the richest workers in the country to pay tax on their labor income at a low rate. Changes in the investment world - the growth of private equity funds, the adoption of portable alpha strategies by institutional investors, and aggressive tax planning - suggest that reconsideration of the partnership profits puzzle is overdue. In this Article, I offer a menu of reform alternatives, including a novel cost-of-capital approach that would strike an appropriate balance between treating returns on human capital as ordinary income and rewarding entrepreneurial activity with a tax subsidy.

While there is ample room for disagreement about the scope and mechanics of the reform alternatives, this Article establishes that the status quo is an untenable position as a matter of tax policy. Among the various alternatives, perhaps the best starting point is a baseline rule that would treat carried interest distributions as ordinary income. Alternatively, Congress could adopt a more complex "cost of capital" approach that would convert a portion of carried interest into ordinary income on an annual basis, or it could allow fund managers to elect into either the ordinary income or "cost of capital" approach. Any of these alternatives to the status quo would tax carried interest distributions to fund managers in a manner that more closely matches how our tax system treats other forms of compensation, thereby improving economic efficiency and discouraging wasteful regulatory gamesmanship. These changes would also reconcile private equity compensation with our progressive tax rate system and widely-held principles of distributive justice.

Keywords: tax, venture capital, hedge funds, private equity, executive compensation, capital gains, partnerships

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