Taxation of Private Equity and Hedge Fund Partnerships: Characterization of Carried Interest

Taxation of Private Equity and Hedge Fund
Partnerships: Characterization of Carried
Interest
Donald J. Marples
Specialist in Public Finance
Government and Finance Division
Summary
General partners in most private equity and hedge funds are compensated in two
ways. First, to the extent that they contribute their capital in the funds, they share in the
appreciation of the assets. Second, they charge the limited partners two kinds of annual
fees: a percentage of total fund assets (usually in the 1% to 2% range), and a percentage
of the fund’s earnings (usually 15% to 25%, once specified benchmarks are met). The
latter performance fee is called “carried interest” and is treated, or characterized, as
capital gains under current tax rules. H.R. 6275, introduced by House Ways and Means
Committee Chairman Charles Rangel on June 17, 2008, would make carried interest
taxable as ordinary income. H.R. 6275 was passed by the House of Representatives on
June 25, 2008. Other legislation (H.R. 2834 and H.R. 3996) made similar proposals.
This report provides background on the issues related to the debate concerning the
characterization of carried interest. It will be updated as legislative developments
warrant.
Background. Most private equity and hedge funds are organized as partnerships.¹
For tax purposes, a partnership is broadly defined to include two or more individuals who
jointly engage in a for-profit business activity. They typically consist of general partners
(who actively manage the partnership), and limited partners (who contribute capital).
General partners may also contribute capital.
According to an administration official, tax considerations likely motivate the
organization of private equity and hedge funds as partnerships.² In general, partnerships

¹ For a more complete description of the tax issues surrounding hedge funds and private equity
managers, see CRS Report RS22689, Taxation of Hedge Fund and Private Equity Managers, by
Mark Jickling and Donald J. Marples.
² Testimony of Treasury Assistant Secretary for Tax Policy Eric Solomon, in U.S. Congress,
Senate Committee on Finance, Carried Interest I, July 11, 2007 at [http://www.senate.gov/
(continued...)

do not pay the corporate income tax and, instead, pass all of their gains and losses on to
the partners. The returns of these partnerships are generally taxed as capital gains. In
addition, the tax rules for partnerships allow sufficient flexibility to accommodate many
economic arrangements, such as special allocations of income or loss among the partners.
General and limited partners are compensated when the investment yields a positive
return. This income, as mentioned above, is not taxed at the partnership level; only the
individual partners pay taxes, usually at the capital gains rate.
In addition, the general partners typically receive additional compensation from the
limited partners. Compensation structures may vary from fund to fund, but the standard
pay formula is called “2 and 20.” The “2” represents a fixed management fee (2%) that
does not depend upon the performance of the fund. It is characterized as ordinary income
for the general partner and is taxed at ordinary income tax rates. The “20” is a share of
the profits from the assets under management (20%).³ This portion of the general
partners’ compensation is commonly referred to as the carried interest. Selecting this
form of compensation aligns the interests of both the limited and general partners toward
achieving a positive return on investment. Carried interest is characterized as a capital
gain and taxed at the capital gains rate. Issues surrounding the characterization of carried
interest are the focus of the remainder of this report.
Character of Carried Interest. Central to the current debate concerning the tax
treatment of carried interest is whether it is compensation for services, or an interest in
the partnership’s capital.⁴ Current law treats carried interest the same as all other profits
derived from the partnership and thus characterizes carried interest as being derived from
an interest in the partnership’s capital. As a result, carried interest is taxed at capital gains
rates, which have historically been lower than the rates on ordinary income. This rate
differential is generally thought to motivate the current structure of compensation received
by fund managers. If carried interests were treated as compensation for services provided
by the general partners, then the realized gains would be characterized as ordinary income,
taxed at generally higher rates, and subject to payroll taxes.
In the United States, debate on the appropriate characterization of carried interest has
been brought to the forefront by both proposed legislation and a series of congressional
hearings on carried interest. H.R. 2834, H.R. 3996, and H.R. 6275 would make carried
interest taxable as ordinary income. The bills state that carried interest “shall be treated
as ordinary income for the performance of services” and thus taxed as ordinary income
at rates up to 35%. H.R. 3996 was passed by the House of Representatives on November

9, 2007, and by the Senate on December 6, 2007, with an amendment that removed the

² (...continued)
~finance/sitepages/hearing071107.htm], visited June 23, 2008.
³ In some cases general partners are only entitled to a share of the profits if the fund surpasses a
minimum rate of return, or hurdle rate.
⁴ A second issue related to carried interest, deferral, is discussed more fully in CRS Report
RS22689, Taxation of Hedge Fund and Private Equity Managers, by Mark Jickling and Donald
J. Marples and in the testimony of Congressional Budget Office Director Peter R. Orszag, Senate
Committee on Finance, Carried Interest I, July 11, 2007 at [http://www.senate.gov/
~finance/sitepages/hearing071107.htm], visited June 23, 2008.

carried interest provision, while H.R. 6275 was passed by the House of Representatives
on June 25, 2008, and subsequently received by the Committee on Finance. In addition,
the Senate Finance Committee and the House Ways and Means Committee have held a
series of hearings on carried interest.⁵
Debate concerning the characterization of carried interest is not unique to the United
States. In fact, the United Kingdom’s Treasury Select Committee has asked HM Revenue
and Customs to explain a 2003 memorandum of understanding that allows general
partners in private equity funds to characterize carried interest as investment income.⁶ In
addition, Table 1 illustrates that European countries have not achieved a consensus view
on the appropriate characterization of carried interest.
Table 1. Characterization of Carried Interest in
the United States and Europe
Characterization Country
as capital gain:Austria, Czech Republic, Denmark, Estonia,
France, Greece, Ireland, Italy, Luxembourg,
Norway, Spain, Sweden, United Kingdom, United
States
as ordinary income:Hungary, Latvia, Netherlands, Poland, Portugal,
Romania, Slovenia, Switzerland
as dividend or other form of income:Belgium, Finland, Germany
^Sources^:^Un^{ited States}^In^tern^{al R}^e^ven^u^e^C^{ode an}^{d Eu}^ropean^P^r^iv^{ate Equ}^ity^an^{d Ven}^t^u^r^{e C}^a^pital
^A^s^s^o^ciation^,^Ben^c^h^m^arkⁱⁿ^g^Eu^ropean^T^a^x^an^{d L}^e^g^a^{l En}^vⁱ^ron^m^en^ts^{, Decem}^{ber 2006.}
Most analysts view carried interest as representing, at least partly, compensation for
services provided by the general partner. In some instances this distinction is clear, but
in others it is more opaque. Analysts generally base their characterization of carried
interest upon the degree to which the general partners’ own assets are at risk and
differences in the profit interest of the general and limited partners.
Some view carried interest as a type of performance-based compensation that should
be characterized as ordinary income. That is, the general partner is being compensated
for providing the service of generating a positive return on the investment. This argument

⁵ U.S. Congress, Senate Committee on Finance, Carried Interest, Part I, July 11, 2007; U.S.
Congress, Senate Committee on Finance, Carried Interest, Part II, July 31, 2007 at
[http://www.senate.gov/~finance/sitepages/hearing073107.htm], visited June 23, 2008; U.S.
Congress, Senate Committee on Finance, Carried Interest Part III: Pension Issues, September
6, 2007; U.S. Congress, House Committee on Ways and Means, Hearing on Fair and Equitable
Tax Policy for America’s Working Families, September 6, 2007 at [http://www.senate.gov/
~finance/sitepages/hearing090607.htm], visited June 23, 2008.
⁶ International Tax Review, Private Equity Scrutiny Targets Tax, August 2, 2007, and House of
Commons, Treasury Committee, Private Equity Volume 1 and 2, July 24, 2007.

would seem to have greater merit in cases where a “hurdle rate” must be reached prior to
the award of a carried interest.
Some also argue for a change in the characterization of carried interest based upon
the economic principles of efficiency and equity. Tax systems are generally deemed more
efficient when they tax similar activities in a like manner. Critics note that under the
current characterization of carried interest, these performance fees are taxed less heavily
than other forms of compensation, leading to distortions in employment, organizational
form, and compensation decisions.⁷ As a result of these distortions they maintain that the
economy misallocates its scarce resources. They also argue that the current treatment of
carried interest violates the principles of both horizontal and vertical equity. That is,
individuals with the same income should owe the same in taxes regardless of the form of
the income, and that those that earn more should pay more in taxes than those that earn
less.
Others view the current characterization of carried interest as appropriate, because
of the general partners’ contribution of “sweat equity” to the fund. That is, the general
partners contribute their management skills to the partnership, in lieu of contributing
capital. Once granted a carried interest, the general partner has an immediate ownership
interest in the partnership, and thus is taxed on the proceeds of the partnership, based
upon the character of the proceeds. Under this view, the limited partners agree to finance
the carried interest through a reduction (relative to their capital investment) in their rights
to the profits of the partnership.
This view, however, highlights a general inconsistency in the tax code, from an
economic perspective — the blurring of the returns from labor and capital. For example,
imagine the case of a sole proprietor who turns an idea into a business. If the sole
proprietor is later able to sell the business for a profit, the tax system will characterize the
profit as a capital gain, though the provision of labor unquestionably contributed to the
increased value of the business. In other cases, such as when nonqualifed stock options
are exercised, the issue is more transparent, and the gain is characterized as compensation
and taxed as ordinary income. Any subsequent gain or loss is characterized and taxed as
a capital gain.
Some have interpreted this “sweat equity” argument to represent an implicit loan to
the general partners that should be taxed somewhere between that of pure capital and pure
ordinary income.⁸ Under this option, the general partner would be viewed as receiving
an interest-free loan from the limited partners equal to share of the partnership represented
by the carried interest. The general partner would count the implicit interest from the loan
as ordinary income.⁹ Subsequent profits from the carried interest would then be taxed as
capital gains.

⁷ Aviva Aron-Dine, An Analysis of the “Carried Interest” Controversy, Center on Budget and
Policy Priorities, August 1, 2007.
⁸ Victor Fleischer, “Two and Twenty: Taxing Partnership Profits in Private Equity Funds,”
University of Colorado Legal Studies Research Paper Series, Working Paper No. 06 — 27 (June

12, 2007).

⁹ The implicit interest is the interest that the general partner would have paid on the loan had it
been made at market rates.

Some view potential modifications to the treatment of carried interest as
unadministrable. In testimony before the Senate Committee on Finance, Treasury
Assistant Secretary for Tax Policy Eric Solomon stated that the current taxation of carried
interest provides certainty for taxpayers and is administrable for the Internal Revenue
Service.¹⁰ He cautioned against making significant changes in these rules, given the
widespread reliance of partnerships on these rules.
Others argued that the current characterization of carried interest contributes to
innovation and adds economic value to the economy. They asserted that venture
capitalists engage in risking time, money, and effort to assist the most compelling
business models to improve the way that Americans live and work.¹¹ Further, they argued
that private equity allows companies to invest in long-term strategies that might otherwise
be ignored by the managers of publicly traded companies forced to keep a close eye on
quarterly earnings.¹²

¹⁰ Testimony of Treasury Assistant Secretary for Tax Policy Eric Solomon, Senate Committee
on Finance, Carried Interest I, July 11, 2007 at [http://www.senate.gov/~finance/sitepages/
hearing071107.htm], visited June 23, 2008.
¹¹ Testimony of Kate D. Mitchell, Senate Committee on Finance, Carried Interest I, July 11, 2007
at [http://www.senate.gov/~finance/sitepages/hearing071107.htm], visited June 23, 2008.
¹² Testimony of Bruce Rosenblum, Senate Committee on Finance, Carried Interest II, July 31,

2007 at [http://www.senate.gov/~finance/sitepages/hearing073107.htm], visited June 23, 2008.