Carried interest has received a lot of attention in the press recently, and a great deal of controversy has long surrounded the issue. Even after all of the explanations in the media, however, few people really understand what carried interest actually is, how it works, and why it matters.
Simply put, carried interest is a method of compensating private equity and hedge fund managers for their work in providing a return on investment for the funds’ contributors. The controversy over carried interest arises because of the fact that tax rules allow those managers to pay taxes on carried interest at the capital gains tax rate rather than the higher tax rate that normally applies to ordinary income.
How Does Carried Interest Work?
Carried interest works like this: say Alan sets up a venture capital fund as a limited liability partnership. He establishes himself as the general partner, which means that he holds the responsibility for managing the fund’s daily operations and bears the liability should something go wrong and lawsuits arise. Alan then finds several other people who want to invest money in the fund as limited partners. This means that they contribute money to the fund, but allow Alan to make the decisions about how to invest the money. They also do not have any liability should things go wrong.
In the simplest form of the situation outlined above, the partners in the fund would receive a share of the fund’s profits that is relative to the amount of money that they put in. In other words, if a partner contributes ten percent of the fund, they would receive ten percent of the profits. Alan would receive his share, plus compensation that would be taxed as ordinary income for his work in managing the fund.
In a scenario involving carried interest, however, Alan would not receive a regular salary for his management work. Instead, he would get a portion of the profits greater than the portion of the fund that he contributed. For demonstration purposes, let’s say that Alan contributed 10% of the fund, but will receive 25% of the profits. This extra share, even though it is in effect compensation for his daily work in managing the fund, is considered carried interest and taxed as a capital gain.
How Is Carried Interest Taxed?
Proponents of carried interest argue that taxing carried interest at the lower capital gains rate is reasonable because there are usually conditions attached to a grant of carried interest that make it a less reliable source of money than a regular salary. For instance, a manager’s carried interest often only becomes available well after the venture has completed, and sometimes only if the investors received a certain rate of return.
Opponents counter that carried interest allows wealthy financiers to avoid paying taxes on money that was earned for providing a service rather than investing in a capital asset. The carried interest, they argue, should be taxed as ordinary income rather than a capital gain.
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