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Taxation of Private Equity and Hedge Fund
Partnerships: Characterization of Carried
Interest
Donald J. Marples
Specialist in Public Finance
March 17, 2010
Congressional Research Service
7-5700
www.crs.gov
RS22717
CRS Report for Congress
P
repared for Members and Committees of Congress
c11173008
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Taxation of Private Equity and Hedge Fund Partnerships
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. In the 111th
Congress, the House-passed Tax Extenders Act of 2009, H.R. 4213, H.R. 1935, and the
President’s 2010 and 2011 Budget Proposals would make carried interest taxable as ordinary
income. In addition, in the 110th Congress, H.R. 6275, would have made carried interest taxable
as ordinary income. 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.
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Taxation of Private Equity and Hedge Fund Partnerships
Contents
Background ................................................................................................................................ 1
Character of Carried Interest ....................................................................................................... 1
Tables
Table 1. Characterization of Carried Interest in the United States and Europe .............................. 2
Contacts
Author Contact Information ........................................................................................................ 4
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Taxation of Private Equity and Hedge Fund Partnerships
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 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
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/~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.
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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 the President’s 2010 and 2011 Budget Outlines, proposed legislation,
and a series of congressional hearings on carried interest. The President’s 2010 and 2011 Budget
Outlines, H.R. 1935, and the House-passed version of H.R. 4213 would make carried interest
taxable as ordinary income. This approach may mirror those taken in the 110th Congress, H.R.
2834, H.R. 3996, and H.R. 6275, in making carried interest taxable as ordinary income. The bills
stated 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 carried interest provision, while H.R. 6275 was passed by the House
of Representatives on June 25, 2008, and subsequently received by the Senate Committee on
Finance. In addition, the Senate Finance Committee and the House Ways and Means Committee
held a series of hearings on carried interest, during the last session.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
Belgium, Finland, Germany
income:
Sources: United States Internal Revenue Code and European Private Equity and Venture Capital Association,
Benchmarking European Tax and Legal Environments, December 2006.
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.
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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 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
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).
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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.
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
Author Contact Information
Donald J. Marples
Specialist in Public Finance
dmarples@crs.loc.gov, 7-3739
9 The implicit interest is the interest that the general partner would have paid on the loan had it been made at market
rates.
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.
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