The Carried Interest Controversy

The Carried Interest Controversy

By David DuWaldt

November 13, 2008

It was just last year that the Senate Finance Committee conducted a few hearings about the controversial tax treatment of “carried interest.”  The website,, provides us with the following definition for the term, carried interest:

“A share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds.  This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund’s performance.”

Given the recent election results and ongoing debate about executive compensation in the midst of the current financial crisis, it should not be a surprise that the tax treatment of income associated with carried interests could be changed as early as 2009.

Under current federal tax law, the character of the income to the carried interest is the same as the income earned by the fund.  Therefore, if most of the profits of the fund consist of long-term capital gains, then the carried interest receives, in direct proportion to its allocated share of profit, the same tax treatment.  So with the substantial income earned by some of the managers of large private equity groups over the past few years, there has been a heated debate over this favorable tax treatment.  At the moment, with a few exceptions, the maximum federal tax rate on long-term capital gains is 15% while the federal tax rate on ordinary income is as high as 35%.

Without any amendments to the federal tax code, the 15% federal long-term capital gains rate is scheduled to expire on December 31, 2010 and, thereafter, move up to 20%.  Some members of the private equity community may believe that the substantial change in the capital markets and a higher capital gains rate in a few years will move this political issue to the sidelines.  With the promise for change by President-elect, Barack Obama, and a democratically controlled Congress, just about anything is possible with regard to changes in the federal tax code.

Let us also keep in mind that the current federal budget deficit problem does not appear to be going away anytime soon.  With Congress looking for new ways to increase tax revenue, it seems logical that ordinary income treatment will soon apply to a carried interest, just as it does for executive compensation reported on Form W-2.