Why Carried Interest Should Not Be Taxed at the Capital Gains Rate

Income made on "carried interests" at private equity firms should be taxed like ordinary income.

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Eileen Appelbaum is a senior economist at the Center for Economic and Policy Research

Private equity firms recruit investors—pension funds, endowments, sovereign wealth funds, hedge funds, wealthy individuals—for an investment fund. The private equity fund is structured as a partnership in which the sponsoring private equity company is the general partner and the investors in the fund are limited partners. The investment fund acquires a portfolio of operating companies with the expectation that the fund will make a profitable exit from the investments in a few years. The general partner (the private equity firm) makes the decisions about which companies to buy, how they should be managed, and when they should be sold. The limited partners share in any gains (or losses), but do not have a say in decision-making. The private equity firm typically sponsors multiple special purpose private equity investment funds, each of which is structured as a separate partnership.

Firms that sponsor private equity funds operate on a "two and 20" model. They typically collect a flat 2 percent management fee on all money committed to the investment fund by the limited partners. The management fees cover the costs of managing the fund and its investments, including payments to members of the private equity firm for work they perform. The private equity firm that sponsors the fund—the general partner in the fund—also receives 20 percent of all investment profits once a hurdle rate of return has been achieved. The remaining profits are distributed to the limited partners in proportion to the capital that they invested in the fund and put at risk. The profits that are received by the private equity firm are referred to as carried interest. They are distributed to the partners in the private equity firm and taxed at the lower capital gains rate, currently 15 percent, not at the top personal income rate of 35 percent. (It is worth noting, as Paul Krugman does, that long-term capital gains were taxed at close to 30 percent from 1986 through 1997 when they were reduced to 20 percent; the current very low rates only started in 2003).

[Read the U.S. News debate: Do the Rich Pay Their Fair Share in Taxes?]

Private equity firms argue that the 20 percent of a private equity fund's profits that they earn are a return on the equity they have invested—the capital they have put at risk—and should, therefore, be treated as capital gains and taxed at the lower rate.

Typically, however, a private equity firm contributes $1 to $2 to the private equity fund for every $100 the limited partners have invested in the fund. Thus, 1 to 2 percent of the fund's profits are a return on the private equity firm's investment in the fund; the remaining 18 percent is a form of profit sharing by the private equity firms' partners. As with other forms of performance-based pay, these earnings should be taxed as ordinary income and not at the 15 percent capital gains rate.

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