Carried Interest Explained

By Stanley Rose March 6, 2017

The term “carried interest” has been in the news a lot lately and not without fervent debate among politicians regarding its tax treatment. Much of the discussion, however, has not only been confusing but inaccurately described as well. What follows here is a robust explanation of carried interest, its current tax treatment, and the plans expressed by our leaders for its future. An executive summary is presented at the end of the article.

Background

First, let’s dispel one reasonable assumption by pointing out that “carried interest” has nothing to do with interest income. It also is not a deduction – of interest or anything else. The term is not even found in the Internal Revenue Code. It instead represents a tax-favorable method of sharing profits. This is explained in layman’s terms below, but a true grasp of it requires familiarity with its context and a basic understanding of differences between general and limited partners in a partnership.

When an investment partnership is formed, it generally is owned by at least two categories of partners: Limited partners and general partners. Limited partners are described as such because their involvement and risk are limited. They usually are not on the hook for partnership liabilities or subsequent claims. They might lose money, but ordinarily it is limited to the amount they invested. They do not participate in the operations of the partnership. General partners are more financially exposed and usually participate in partnership operations. Limited partners could be loosely characterized as outside investors, while general partners could be described as owner/operators.

How partners are paid in the absence of carried interest

It seems logical to most that an outside investor (limited partner) would receive favorable capital gain treatment on his or her investment. You make an investment, back off and let it grow, harvest it, and laugh your way to the bank with long-term capital gain and its favorably low tax rates (now capped federally at 20%).

That logic also would accept that the owner/operator of an endeavor (general partner) would be remunerated in a way that more closely resembles wages.  You pack a lunch pail and a thermos, go to work, slave over a hot computer all day, generate some income for your investors, and laugh less hard on your way to the bank, because your pay is taxed at high ordinary rates (now capped at 39.6%) and is subject to employment taxes as well.

In an investment partnership, management fees may take the place of wages, but you get the point – owner/operators and general partners receive wage-like ordinary income, while outside investors/limited partners receive capital gains as their investment grows.

How partners are paid using carried interest

Many partnerships reward general partners by allocating to them a portion of gains realized when the partnership or investments held by the partnership are sold. Their “pay package” often consists of (1) wages or management fees plus (2) a share of the gain. The term “carried interest” simply refers to this allocation of gain.

The issue

Detractors see carried interest as tantamount to an employee who is paid with long-term gains instead of wages, which cuts the recipient’s taxes dramatically. They focus on the fact that a service is being provided, and in their view, anything given in exchange for services should be taxed at ordinary rates.

Supporters focus on what is being produced: The general partner’s efforts are, in fact, producing long-term gain. Those partners have skin in the game, and they are incentivized to share in the reward. No one takes issue with a day trader pocketing his or her own personal gain and receiving capital gain treatment for the long-term investments. How is this any different?

So what is it – pay for services, or sharing of the growth? Arguably, it contains pieces of both, and there is logic to both sides’ arguments. However, most of the people receiving carried interest are not living paycheck to paycheck. Some managers have collected extremely large profits, and paid half the tax rate of their counterparts in other industries (or colleagues in the same industry who have different arrangements), simply by receiving carried interest. This understandably does not play well in many circles. The U.S. has a graduated tax rate system (the higher the income, the higher the applicable tax rate) and carried interest often reverses that structure somewhat.

In the crosshairs

Historically proposed (but never materialized) fixes arguably were designed to curb these benefits for large hedge funds, but contain language with a wide enough net to ensnare other industries as well, like real estate development.

While Trump’s debate comments and tax plan suggest that carried interest simply will no longer be eligible for favorable rates, he proposes so many other changes to the tax code that it is confusing how this “neutralization” would truly play out. He proposes a general top individual ordinary rate of 33% and a top capital gain rate of 20%. By itself, that implies carried interest would be taxed at 33%. However, he also has proposed lowering the tax rate applicable to flow-through income (of which carried interest is a part) to 15%. This implies that carried interest could lose one favorable tax status only to qualify for another. Trump’s plans share very little detail on self-employment tax, but it is possible that could impact carried interest as well.

It is difficult to see how this is resolved unless something else is added to the proposal that has not yet been articulated. Perhaps it involves flow-through income being for the first time subjected to a second layer of tax, similar to taxable C-corporations (a topic for another day), or a carve-out that places carried interest in its own, unique (and unfavorable) category.

My guess? It seems unlikely that Donald Trump will allow any significant disparity to remain, given his repeated promises to eliminate the favorable treatment. We will just have to wait for more details to see how it happens.

 

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Executive summary

• Carried interest is not interest income, interest expense, or a tax deduction.
• Carried interest is a common method of allocating certain types of gain to the partners in a partnership that were most responsible for generating the appreciation in value that produced that gain.
• The type of income allocated is tax-favorable (long term capital gain).
• Why is it a hot topic? Carried interest has been used to pay enormous amounts to hedge fund managers who serve as general partners in investment partnerships. Those managers caused investments to appreciate in value and create long-term capital gain, but many believe such remuneration should be taxed as ordinary income, like management fees or wages – because the recipient was providing services.