Carried Interest
The most controversial new tax law being debated in Congress is a new tax on carried interest. If you listen the media, the debate is about balancing the budget on the left versus “the war on wealth” on the right. What has been lacking in the coverage is facts and logic.
Carried interest is, in effect, profit sharing for the managers of hedge funds, venture capital firms, and other partnerships. These partnerships usually charge the non-managing partners a percentage of profits in addition to a fixed fee. The percentage of profits charged is called a carried interest.
Currently, the carried interest is taxed as a capital gain. The new law would tax it as income. People should not be asking whether this is a good revenue source or whether this is an attack on the rich. The question is whether the character of this gain is a capital gain or income.
The logical answer to this (and this is obviously not a self-interested conclusion as I run a hedge fund) is that this is income. Carried interest is a performance-based bonus earned by the managers of the partnership. Bonuses are taxed as income.
Capital gains are taxed at a reduced rate because the capital has already been earned as income and taxing capital gains at a high rate would, arguably, be over-taxing. Carried interest is not a return on capital already earned. There is, in fact, no capital. It’s awkward to argue that it is a capital gain when there is no capital at risk.
While I empathize with other hedge fund managers arguing against a “new” tax, the problem is that it is a loophole being closed rather than a new tax. The character of the gains is clearly income, rather than capital gain.
