Private Equity and the Treatment of Carried Interest: An Overview
Carried Interest: What It Is
A critical component of the American economic system is the principle that those who create value by their work should be rewarded. Carried interest is just another name for the way partnerships divide the rewards of a joint venture between the partners who provide capital and those who provide sweat equity. Carried interests are found throughout industries and market segments in which one party invests capital and another invests expertise or “sweat equity”. For example, real estate developers typically receive carried interests when they develop office buildings or other properties. Venture capital firms and small business investment companies receive carried interest when they invest in new start up businesses. In sum, carried interests have come to be used as equity incentives for owner-managers across the full spectrum of businesses and, indeed, are a core part of the entrepreneurial risk-taking so central to the American economic system. Changing the tax treatment of carried interest will have widespread ramifications, adversely affecting start-up ventures, small businesses, interests in real estate and natural resources, and other enterprises.
Carried Interest and Private Equity Firms
Private equity funds are partnerships formed to acquire large (often controlling) stakes in growing, undervalued or underperforming businesses. Outside investors, including public employee and private pension funds (the “limited partners”), generally contribute 90 to 97% of the equity capital used to acquire the businesses. The sponsor of the fund (the “general partner”) provides the remaining 3 to 10% of fund capital. In addition to any actual cash capital it invests in the fund, the general partner typically receives an equity interest in the future profits of the fund. This equity interest, which is known as the “carried interest,” is provided in recognition of the substantial, material, hands-on, work of the GP in structuring and directing the investments of the fund. The carried interest provides the general partner with upside potential similar to the potential afforded to the limited partners, and serves as to align the general partner’s interests with the limited partners. If the fund does well, the general partner shares in the gains; if the fund does poorly, the general partner may receive nothing.
Tax Treatment of Carried Interest Under Present Law
Under current law, investments made by private equity funds are treated as capital assets, and the general partner’s carried interest share of the net gains realized by the funds on disposition of those assets is taxed on a “pass-through” basis as capital gain.
The present-law tax treatment of carried interests is founded on two sound and settled tax policies. The first is that capital gains are designed to reward entrepreneurial investments of labor, as well as capital. The second is that partnership profits should be taxed on a “pass-through” basis.
Rewarding Entrepreneurial Investments
The justification for a reduced tax rate for long-term capital gains is based on the concept of entrepreneurial investment. Capital gain treatment is intended to reward those who invest in capital assets and realize capital gains. The requisite entrepreneurial risk-taking is not limited to capital investments; it also extends to investments of labor. Our tax system has long recognized that a taxpayer may be entitled to capital gain treatment with respect to the sale or exchange of property where the gains are attributable in whole or in part to the taxpayer’s own personal efforts. The key criterion for capital gain treatment is not whether the gains are attributable to capital or to labor. Rather, the key criterion is whether the taxpayer has made an entrepreneurial investment — of capital or labor — in a long-lived asset, the return for which depends entirely on the value of the asset.
For example, if the owners of a small operating business builds its value through their own efforts, their interest in the equity of the business is treated as a capital asset, and their gains on sale are treated as capital gain. This is true even where they have made the vast majority of their investment — perhaps all their investment — through their labor, rather than cash capital.
The same principles apply in the pooled investment context, where the partners join together to invest capital and labor. The value of a real estate fund’s assets is enhanced by the skill of its developer-general partner in identifying attractive buildings, engaging experienced management services, and positioning the real estate for optimal returns on sale. And the value of a private equity fund’s investments is enhanced by the skill of its sponsor-general partner in identifying undervalued companies, arranging financing, developing and implementing management and operating strategies, and selling at attractive valuations.
The core notion of partnership taxation is that partners receive a “distributive share” of income jointly derived from pooled labor and capital. In private equity partnerships, the general partner’s carried interest economically represents a share of the gains and losses of the fund. Unlike fixed compensation which is properly taxed as ordinary income, the carried interest rewards the general partner only if the fund actually has net gains over its entire term. Because the carried interest is actually based on the partnership’s gains and losses, the current tax treatment of carried interest on a pass-through basis properly expresses the underlying premise of partnership taxation.