The Fallacious Objections to the Tax Treatment of Carried Interest
22 Pages Posted: 5 Oct 2016 Last revised: 31 Jan 2017
Date Written: October 3, 2016
Carried interest is the term used to describe a profits interest in a partnership that invests in entities. A managing partner typically will receive a 20% profits interest in exchange for managing the investments of the partnership. The complaint against the treatment of carried interest is aimed at the characterization of the managing partner's share of the partnership's subsequent capital gains. The contention is that since the managing partner receives her share of the partnership's income for services performed, she should be taxed at ordinary income tax rates rather than the preferentially lower capital gains rate.
The tax treatment of carried interest has become a notorious bete noire for many politicians and some academicians and practitioners. Both presidential candidates have denounced the current tax treatment and vowed to change it. President Obama described the current treatment as a "tax loophole" which should be closed. Others have also characterized the current tax treatment as an abusive loophole. This article takes the contrary position. It is the thesis of this article that those criticisms of the tax treatment are unfounded. To the contrary, the current tax treatment accords with sound tax policy and is proper and appropriate. When the tax treatment of self-created property is considered in the context of the current and proper tax treatment of partners and partnerships, it becomes clear that the allocation of a portion of the partnership's capital gains to the managing partner is not a payment for services and is correctly treated by the managing partner as capital gains.
Keywords: Carried Interest, Capital Gains, Profits Interest, Tax, Partner, Fund
JEL Classification: H2, H24, H25, H26, H29, G24
Suggested Citation: Suggested Citation