Carried Interest Debate (Wiki Page)

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Carried Interest Debate (Wiki Page)
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Private Investment Fund

Before considering carried interest, one must first have a basic understanding of the organizations that currently benefit from it. Private investment funds, set up as limited liability companies or limited partnerships, invest capital in order to attain returns for investors. These funds are organized under general partners and limited partners. The general partners are the funds' managers or managing firms. The limited partners are the funds' investors who typically include pension funds, insurance companies, and wealthy individuals. Types of private investment funds consist of private equity funds, venture capital funds, and hedge funds. In reality, the lines between these types of funds can often be blurred, but the key distinctions can be summarized as follows:

Private equity funds generally invest in large companies with the intent to restructure and sell the firms for a gain. These investments usually entail the acquisition of private companies, but they may also involve acquiring controlling interests in public companies through stock purchases. Private equity funds usually employ a long-term, hands-on approach to investment.
Venture Capital funds aim to invest in small to medium-size startups with high-growth potential in exchange for a stake in the company. Once the fund purchases a stake in the company, it also provides coaching and other services to the company in order to increase its chances of success. Similar to private equity funds, venture capital funds invest with a hands-on, long-term strategy with the eventual goal of a liquidity event.
Hedge funds focus on achieving high returns through risky, short-term investments that may come in the form of stocks, bonds, commodities, derivatives, and anything else that promises a quick gain. Accordingly, hedge funds tend not to adopt the same hands-on approach to investment that venture capital funds and private equity funds take.

What is Carried Interest?

Recall the structure of a private investment fund. General partners are compensated for managing their private investment funds through management fees and carried interest. Management fees are consistently around 2 percent of a fund's assets under management and are paid regardless of the fund's performance. Carried interest, alternatively, serves to join the incentives of the general partners with the interests of the limited partners by providing performance based compensation for the general partners. When a fund surpasses its hurdle rate of return, usually about 8 percent, the general partners will typically receive around 20 percent of the profits as compensation. This 20 percent, in combination with any other profit the general partner may receive from their own stake in the fund, is treated as a capital gain for tax purposes. The 2 percent management fee is treated as ordinary income for tax purposes. The maximum rate for a capital gains tax is 20 percent, compared to the maximum rate for an ordinary income tax of 39.6 percent.

What is the Debate?

Those who argue against treating investment funds' profits as capital gains have two primary points. The first of which is that carried interest is only taxed when it is realized. Through this tax deferral, the carried interest can benefit from the time value of money. Thus, the general partners at the private investment funds then have what some perceive to be unfair tax advantage. The second and more emphasized point is that carried interest is subject to the capital gains tax rate mentioned in the previous section. Opponents of such treatment consider carried interest to be a performance based compensation, much like a bonus, and accordingly believe it should be taxed at the ordinary income rate. In their argument, the opponents frequently compare general partners' roles to those of corporate executives and mutual fund managers who are subject to the ordinary income rate.

Those in favor of the current treatment of carried interest argue that the general partner's role is more analogous to that of an entrepreneur. Just as an entrepreneur sells his or her business and is taxed at the capital gains rate, so too should the general manager be taxed on his or her realized gains at the capital gains rate. Further, it is claimed that a higher tax rate would reduce incentive for general partners to take risks. This lack of incentive would then discourage innovation and efficiency in markets. Although, it is not clear whether there is evidence for these claims or if the risks general partners take on provide a benefit to the economy as a whole.