Carried Interest: What Is it? An Explainer
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The Fiscal Times
February 4, 2013

When it comes to closing tax loopholes at a time of tremendous fiscal challenge, a type of income known as carried interest almost always gets a sharp look.

It was a hot-button issue last year, since over 30 percent of GOP presidential candidate Mitt Romney’s income in 2010-2011 was in carried interest and thus taxed only at a 15 percent rate, instead of at the marginal tax rates on ordinary income that, in 2013, now go as high as 39.6 percent.

Even then, the issue was hardly new. President Obama has tried to repeal the loophole in each budget he’s submitted to Congress, and this weekend he made a point of mentioning that taxing the carried interest rate paid by private equity and hedge fund executives could help bring down the deficit.

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The Tax Policy Center at the Urban Institute and the Brookings Institution defines carried interest this way: “Carried interest is a right that entitles the general partner (GP) of a private investment fund to a share of the fund’s profits. Typically, the GP contributes 1 to 5 percent of the fund’s initial capital and commits to managing the fund’s assets. In exchange, the GP receives an annual management fee of 2 percent of the fund’s assets plus a ‘carried interest’ of 20 percent of the fund’s profits that exceed a (previously agreed-to rate) of return.”

Private equity managers usually take the first 20 percent of any returns on capital as their share for managing the investment. Hedge funds’ performance fees have also averaged about 20 percent historically but have had greater variability, in extreme cases reaching as high as 50 percent of a fund’s profits.

The returns from private equity funds typically qualify as long-term capital gains and thus receive favorable tax treatment. In a hedge fund environment that deals with active, liquid investments, carried interest can be paid annually if the fund has generated a profit for its investors.

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Capital gains are treated differently than ordinary income – a break that some consider unfair, while others insist the loophole is necessary to create the incentive for investors to put their capital at risk in ways that can generate jobs and income for other Americans.

The question surrounding carried interest is whether it should be treated as ordinary income or capital gains, but most analysts agree that at least a portion should qualify as ordinary income. “Few if any analysts believe that carried interest represents entirely a return to capital rather than labor,” the Tax Policy Center noted in an analysis. 

Most capital gains in the U.S. are earned by people in the wealthiest 1 percent of the population – and a growing share of U.S. income comes from earnings on invested capital (capital gains, interest and dividends) rather than from wages and salaries.

According to the CBO, between 1979 and 2007 the top 1 percent of households saw their income grow by 275 percent; the next 19 percent saw their income rise 65 percent; the next 60 percent saw their income rise 40 percent; while the bottom 20 percent saw their income rise just 18 percent.

Jack Lew, Obama’s former budget director, said in September 2011 that raising the tax rates on carried interest income to ordinary income rates would bring in $18 billion to the federal government. The private equity industry has pushed back hard. “Raising taxes on investments would only sideline employers and investors and create further uncertainty in an already struggling economy,” said Steve Judge of the Private Equity Growth Capital Council, the industry’s trade group, according to The New York Times. 

Today, others continue to decry the lack of fairness – saying that money earned, whether from investments or labor, should be taxed the same.

Sources: Tax Policy Center, Politico, Wikipedia 

 

Managing Editor Maureen Mackey oversees scheduling and work flow and also writes and edits features and reports. She spent more than 20 years as a senior book and features editor at Reader’s Digest.