"Carried Interest" in private equity: Capital gain or performance fee?

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The debate now taking place in Congress on the tax paid on "carried interest," by private equity and hedge fund managers was not triggered by the initial public offering of The Blackstone Group, the private equity firm headed by Steve Schwarztman, but details of Schwarztman's total earnings that were revealed in the filing brought increased media attention to the issues being debated.

Much of the discussion in Congress and the media centers on whether the "carried interest," which is a major component of the managers' total compensation, should be taxed, as it now is, as a capital gain at 15 percent, or as earned income at 35 percent, because the manager of the fund is directly involved in the activities of the fund.

Senate Finance Committee Chairman Max Baucus (D-MT) described the compensation paid to private equity managers as consisting of a "2 percent management fee and 20 percent of the profits" of the fund when the initial investment is returned to outside investors and the fund exceeds a certain level of profit. The 20 percent interest in the profits is awarded to the manager when the fund is created and is called a "carried interest."

The "carried interest" provision in the law arises from a time when fund managers invested in the funds they managed, assuming a level of risk, according to tpmcafe.com. But while the carried interest in private equity funds is derived from a gain on invested capital, The New York Times says, it is not the manager's capital. Private equity managers are not required to and usually do not invest in the funds. Former Treasury Secretary Robert Rubin's noted this distinction last month at a conference saying that ''I think what they're doing is getting paid a fee for running other people's money.''

At a Finance Committee hearing on Tuesday, Bruce Rosenblum, managing director of the Carlyle Group supported the capital gains interpretation. A change would mean that "there will be deals that don't get done. There will be entrepreneurs that won't get funded and turnarounds that won't get undertaken," he said according to MarketWatch.

Tax scholars speaking at the hearing argued that the current tax system rewards fund managers while other professionals like doctors and teachers pay twice as much.

Bills introduced by the House and Senate finance committees on the taxation of private equity differ, with the Senate bill introduced on June 14 by Senator Baucus and Senator Charles Grassley (R-IA) doubling the taxes paid by private equity firms, but only those that go public like the Blackstone Group.

The House bill, sponsored by Michigan Democrat Rep. Sander Levin and supported by House Ways and Means Chairman Charles Rangel, Financial Services Chairman Barney Frank and a dozen lawmakers, requires partners at private equity firms, both public and private, to pay ordinary income tax rates of as much as 35 percent on "carried interest," instead of the capital-gains rate of 15 percent, wsj.com reports.

The issues encompassed by the bills, and the debates surrounding them, are more complex than just the question of whether "carried interest" is passive income, touching on both tax law and politics.

Whether the private equity partnerships should "retain their exemption from being treated the same as corporations when they go public and [the question of whether] the managers of these firms [should] continue to be able to receive capital gains treatment (depending on the nature of the partnership's assets) when they are paid on their 'profits interest' in the partnership, which is their compensation for providing services," also becomes part of the discussion, according to ataxingmatter.blogs.com, operated by Linda Beale, tax law professor at Wayne State University. This blog recommends that "the 20-year-old publicly traded partnership provision with its exception for investment income should be modified to treat companies like Blackstone as corporations."

Democratic Finance Committee members, Senators Charles Schumer of New York and John Kerry of Massachusetts do not support the Senate bill in its present form because, according to Schumer, it singles out publicly traded partnerships in the financial sector and does not apply equally to partnerships in the oil and energy sector or in real estate that enjoy a similar tax benefit. An exception to the tax code was granted to these firms in 1987 that gives favorable tax treatment to publicly traded partnerships earning more than 90 percent of their income from passive investments, bloomberg.com reports.

The Senate bill, which would tax private equity funds, would also extend the 1987 break to publicly traded partnerships that transport and store ethanol, a corn- based fuel additive, expanding the special treatment, bloomberg.com says.

Senator Kerry told the Senate hearing on Tuesday that they "had to think carefully" about any unintended impact that might come from singling out one piece of the tax code for reform, Reuters reports.

Republicans in both houses oppose both bills and any tax increases. The House bill is not expected to go to the Senate "any time soon," according to a research report by the Stanford Group, Co. but the Senate bill is likely to clear the committee by the fall.

You can read more in-depth analysis of the carried interest issue.

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