Taxing Investment Fund Managers Using a Simplified Mark-to-Market Approach

Abstract

For several years, a debate has swirled around the taxation of hedge fund managers’ compensation. Because it is structured as a type of partnership interest in the hedge fund, hedge fund managers may be eligible to pay taxes at lower capital gains rates on a large percentage of their income from the fund, which seems intuitively unfair. Until now, the debate has generally revolved around whether this compensation, called “carried interest,” is more like compensation, taxable at a 35 percent rate, or is more like an investment return, taxable at a 15 percent rate. And, because strong arguments support analogizing carried interest to both compensation and investment income, there is no clear resolution to the debate.

This Article argues that asking what carried interest most resembles is the wrong question. Instead, it asks whether the policy considerations employed to justify taxing capital gains at lower rates apply equally to carried interest. Because those policy considerations do not strongly support taxing carried interest at lower rates, it is not necessary to determine what carried interest most resembles. Moreover, taxing hedge fund managers’ receipt of carried interest using a simplified mark-to-market approach better solves the problems that weakly justify taxing carried interest at lower rates better than the lower rates solve the problems. Mark-to-market taxation provides the best representation of economic income. Because of liquidity and valuation concerns, however, the tax law generally requires realization before imposing tax. Carried interest does not present these liquidity or valuation problems, however, and can and should be taxable on a mark-to-market basis.

Keywords: carried interest, mark-to-market, hedge fund, private equity fund, investment fund, deferral, preferential tax rates, capital gains, ordinary income, profits interests

JEL Classification: G24, H25, K34