WSJ: Think Twice Before Raiding Carried Interest
By Pam Hendrickson
Ms. Hendrickson, the chief operating officer of The Riverside Company, a private-equity firm, and a member of the Private Equity Growth Capital Council, and vice chairman of the Association for Corporate Growth.
Members of both political parties seem to be inching toward the conclusion that a simpler, fairer tax code will help unleash America’s economic engine, providing businesses with the clarity and certainty they need to invest, build and innovate for the future.
That’s progress, but the politics of comprehensive tax reform are tricky. Carried interest is a case in point.
Some have characterized it as an unfair loophole that must be closed. But from where I sit, any policy that ensures that capital can flow freely to businesses seeking to grow and create jobs is crucial. And that is why the current tax treatment of carried interest — as a capital gain — is entirely appropriate.
Private-equity funds partner with investors, usually public and private pension funds, university endowments and charitable foundations, to buy companies they can improve over time with an injection of capital, a dose of management expertise and a fresh vision for growth. These investors often require private-equity firms to make a substantial personal investment in the fund to further align the interests of all involved.
If the company succeeds, the fund can sell it for a profit and make money for its owners. That brings us to carried interest — and requires a short detour into partnership tax law.
Private-equity funds are organized as partnerships. Investors are the limited partners and receive an 80% ownership interest in the fund. The firm itself serves as the general partner and retains a 20% ownership interest in the fund, known as a carried interest. Carried interest is only paid out after the investors receive a guaranteed return on their investment.
Since the inception of the Internal Revenue Code in 1913, one basic tenet of partnership law is that individuals are taxed based on the character of the partnership’s profits, meaning that if the partnership receives a capital gain, so does the individual partner.
Private-equity funds buy and sell companies, which no one disputes are capital assets. As a result, the tax code makes clear that the profits realized from the sale of those assets should flow to the limited and general partners of the fund and be taxed as capital gains.
Treating carried interest otherwise would single out one form of investment partnership and deprive private-equity, venture capital and real-estate partnerships of the same tax treatment that is afforded to any other investor that owns a capital asset for more than a year and sells it at a profit.
It would also ignore the inherent risk associated with buying and selling companies. A carried interest is worthless if the fund doesn’t turn a profit. And, in many cases, carried interest is subject to a claw-back provision that requires money be paid back to the fund if the limited partner investors do not receive a target level of return on their investment. This makes the nature of carried interest fundamentally different than salary.
To read the full article, please click here.
