Taxation of Carried Interest: An Annotated Bibliography

Taxation of Carried Interest in Private Equity Firms and Hedge Funds

Just in the past few years, private equity firms and hedge funds have had a huge increase in both the quantity of funds as well as the profits earned by such funds. Private equity and hedge funds are alternative investment vehicles that invest in many different asset classes. These funds are set up as partnerships with the manager of the fund being the "general partner" and the investors being "limited partners." Most private equity firms and hedge funds employ and "2 and 20" fee structure to generate profits. What this means is that every year, the firm takes in 2% of assets under management (AUM) as a management fee for managing the fund. It also takes 20% of any profits earned during the year leaving the investors (limited partners) 80% of profits earned. This 20% of profits is known as carried interest. The management fee is taxed at the ordinary income tax rate, generally 35%. Because the fund is legally a partnership, current law states that money earned in carried interest can be taxed at the capital gains tax rate of 15%. Essentially, private equity and hedge fund managers are effectively paying a lower tax rate than the secretaries in their offices do. Is this fair?

At first review, it seems that those fund managers should be an ordinary income tax rate for money earned through carried interest. One reason is that the managers invest little to none of their own money in the fund. The managers use their own financial expertise to generate profits from what the investors put into the fund. Then managers walk away with a portion of those profits. Some argue that the managers are barely "working" yet earn so much tax benefit. The moral implication is that the working middle-class of America pay much at a much higher tax rate than the fund managers who earn hundreds of millions, if not billions of dollars a year.

The other side of the issue presents a dilemma as well. Private equity firms and hedge funds are not the only entities that are set up as partnerships which gain from carried interest. Real estate partnerships are also set up that way. Real estate partnerships do not hold nearly as much value in assets under management as private equity firms and hedge funds do. Hence, an increase in the tax of carried interest will negatively affect those involved in real estate partnerships. With an already weakened real estate market, such tax increases could have a significant impact in the industry. Congress has been debating this issue since last year and has yet to come to a resolution. It will be interesting to see what outcome occurs and how it will affect the financial industry.

Many of the resources included in this annotated bibliography provide information about carried interest and the controversy that surrounds it. Resources examining specific topics within the broad topic of carried interest taxation are included to provide a unique view into specific parts of the controversy. Some of the articles discuss arguments being made in Congressional hearings which indicate the national importance of the issue. Also, several sources provide a detailed background of private equity firms and hedge funds and exactly how they make money.

Annotated Bibliography

Raising tax on private equity could cut critical investment. 2007. The Washington Post, August 6, 2007, sec Financial.

In this article, published by the Washington Post, the author mainly uses an excerpt from Bruce Rosenblaum’s speech to the Senate Finance Committee. Bruce Rosenblaum is a partner for the well known and established private equity fund, Carlyle Group, based in Washington D.C. This source is valuable in that it presents the side of the issue that most citizens are not looking at. Rosenblaum argues that an increase in taxes for private equity firms would do more harm than good. Undeniably, the source has bias as Rosenblaum stands to not gain a good portion of profits from carried interest if Congress decides to raise taxes for private equity firms. However, the source provides a look into the perspective of a private equity partner and their justification for no tax increases.

Aron-Dine, Aviva. An analysis of the "carried interest" controversy. Center on Budget and Policy Priorities (8/1/2007).

The research report by the Center on Budget and Policy Priorities provides a detailed analysis of the carried interest controversy. The author points the fact that private equity managers who earn over $500 million dollars can pay a smaller share of their income in taxes as compared to most middle class families in the US. She concludes that taxing carried interest at a different rate reduces the efficiency of the tax system. Namely, people will design plans to show regular income as capital gains income to reduce tax payment. Hence, this will lead to increased tax fraud and overall inefficiency. The Center on Budget and Policy priorities is a leading policy organization that does much research in the area of fiscal policy. Inherently, the arguments placed by the author are valid and indicate expertise in the area of tax reform.

Barber, Felix, and Michael Goold. 2007. The strategic secret of private equity. Harvard Business Review 85, (9) (09): 53-61.

This journal article lays out the private equity strategy. The authors discuss why the private equity boom has been occurring and why the strategy that private equity firms use works effectively. In the past, huge public companies would buy up completely unrelated businesses, revamp management, and hold them for several years to earn a gradually diminishing return. However, private equity firms, which are essentially pools money from institutions, pension funds, and wealth investors, buy up whole public companies and take them private. Then, by restructuring management or simply getting rid of unprofitable business units, the firms increase cash flow as well as net income. The article gives a detailed introduction into private equity and some of the advantages that private equity firms have. This article is mainly expository and the authors do not impose much bias to sway the reader’s opinion.

Citizens for Tax Justice. 2007. Myths and facts about private equity fund managers - and the tax loophole they enjoy. Citizens for Tax Justice, (accessed 1/31/08).

Citizens for Tax Justice is a group of people who aims to provide ordinary citizens the chance to be involved in the development of tax laws. Therefore, it has written this report to explain to citizens the unfair tax loophole that private equity fund managers enjoy when being taxed at the 15% capital gains rate on carried interest that they earn at their funds. Its target audience is the ordinary citizen and its main purpose is to inform these people about this wrongdoing. This report presents the more popular view of increased taxation for private equity managers. The report discredits much of the myths around the issue but fails to adequately provide cited sources for the points that it does argue. The bias for this report is towards the ordinary citizen who does not enjoy the tax loophole that private equity managers do.

Conway, Kevin. 2007. Tax considerations fan the private equity boom. Financial Executive 23, (7) (09): 37-9.

This article from the Financial Executive, analyzes the private equity boom and the tax advantages that private equity managers receive. An interesting thing about this article is that provides the reader with the perspective of a tax professional from the United Kingdom. Therefore, this article takes into account both the US and UK private equity boom. Some of the main points discussed include fund setup, tax benefits, fund investment structure, and exit strategies for private equity funds. The author, Kevin Conway, does not support one side of the issue; rather, he presents the facts and compares the tax treatment in the US with the UK. In doing so, he limits bias and allows this source to be a solid primer of the tax advantages of private equity firms.

Donmoyer, Ryan J., and Carmichael, Kevin. Paulson warns of "unintended" fallout in taxing funds. . Available from http://www.bloomberg.com/apps/news?pidnewsarchive&sidalm0Crt0eICY.

This article published by Bloomberg reports the views from several different people who have much influence in the financial world. The authors of the article cited Henry Paulson, who believed that Congress should be careful about taxing hedge funds and private equity firms on carried interest due to “unintended consequences.” The article provided a brief introduction about the bill put forth by Max Baucus and Charles Grassley to reform the tax law regarding carried interest. The authors portray the situation in a fairly balanced manner. However, with the title, as well as the lengthy description of Treasury Secretary Paulson’s belief against carried interest taxation, it seems that the authors are biased towards one side. Overall, this article provides a quick overview of different perspectives of people who are influential in the financial world.

Filisko, G. M. 2007. Tax witch hunt against private equity? National Real Estate Investor 49, (9) (09): 80-.

In this journal article, G.M. Filisko discusses the negative impact that taxation of carried interest will have on real estate partnerships. The bill that was presented to the house by US Rep. Sander Levin would treat income earned by partners who perform investment management as investment income. Private equity funds and hedge funds generally have hundreds of millions or billions of dollars in assets under management. Real estate partnerships, in fact do not generally hold as much. Therefore, an increase in the tax rate for such partnerships would significantly diminish what the general partners in real estate partnerships earn. The author is an attorney who frequently writes about legal and real estate issues, and therefore, carries a scholarly understanding of the issue.

Forbes, Steve. 2007. Private equity, public benefits. Wall Street Journal - Eastern Edition, 07/25, 2007, sec 250.

Steve Forbes writes about how private equity firms are a boon to the public and the American economy. He argues that private equity firms add value to American firms and focus on long-term growth rather than the short-term pressures of the financial markets. Forbes also argues that over 111 billion dollars is invested by state government pension funds. Forbes, himself, is the reputable editor-in-chief of business magazine Forbes as well as president and chief executive officer of its publisher, Forbes Inc. There for he has solid background in business with extensive experience in business analysis. The author could be slightly biased because Forbes Inc. gave a minority stake to private equity firm, Elevation Partners. However, Forbes blatantly states that in this article, which indicates that he has seen from experience, the benefit private equity firms bring to companies.

Halonen, Doug. 2007. Fight over tax plan splitting lobbyists. Pensions and Investments (May 28).

This article provides a dual-sided view to the issue at hand. The National Venture Capital Association is attempting to separate itself from hedge funds by stating that it provides more value than hedge funds do because venture capital firms user longer-term economics rather than shorter-term economics. Doug Halonen provides general information to the issue of taxation of carried interest in limited partnerships. He also uses direct quotes from lobbyists, venture capital firms, hedge funds, attorneys, and other key players in the issue at hand. Overall, it has limited bias to one side of the issue but is mainly written to detail what is going on in Washington D.C. in relation to the issue.

Mankiw, Greg. The taxation of carried interest. . Available from http://gregmankiw.blogspot.com/2007/07/taxation-of-carried-interest.html.

This article is from the blog of Harvard Economics Professor, Greg Mankiw, where he discusses the latest trends in economics. In this blog posting, he argues that deferred compensation, such as carried interest, should be taxed like normal compensation. Mankiw points out the fact that an author who puts in hard work for a risky return in the future, gets taxed more than an investment manager who essentially does the same thing. Mankiw does not get very detailed about his point of view; rather, he provides external links that support his side of the argument. This source is beneficial because it shows the personal opinion of a well-respected economist. Mankiw was the chairman of the Council of Economic Advisors from 2003-2005. However, since it is a blog, there tends to be much bias towards Mankiw’s point of view; he barely addresses the other side of the issue.

National Association of Industrial & Office Properties. Carried interest taxation. . Available from http://www.naiop.org/governmentaffairs/issues/carriedinterest.cfm.

This article, by the National Association of Industrial and Office Properties, provides a positional view to the issue of taxation of carried interest. The NAIOP opposes any change to the tax law regarding carried interest because it would severely affect the already weakened real estate industry. The article provides an overview to the situation and it goes on to describe the operation of real estate venture capital funds whose managers use carried interest as a means to ensure that the general partners will do what is beneficial for both the investors and themselves. As evident, the article provides a biased point of view, as the NAIOP is an organization for developers, investors, and other professionals in the commercial real estate industry. This article is beneficial because it provides a unique view to the issue of carried interest from those who would be severely negatively affected if the law were changed.

Needham, Andrew W., and Anita Beth Adams. 2004. Private equity funds. Tax management portfolios; 735. Washington, D.C.: Tax Management.

This book provides a detailed overview and analysis of both private equity and hedge funds. Initially, it discusses the basics such as fund types and essential structure. The authors then discuss certain tax issues in regards to private equity funds and hedge funds. What is beneficial is that the authors cite many external sources including tax law, which indicates a high level of research involved in the writing of this book. It also shows the authors adding their own ideas to the amalgam of past scholars. This book primarily was created to inform the reader than persuade him to one side.

Orszag, Peter R., and United States Congressional Budget Office. 2007. The taxation of carried interest statement before the committee on ways and means, U.S. house of representatives. CBO testimony. Washington, D.C.: U.S. Congressional Budget Office.

This book is a government document that provides the statement of Peter Orszag before the Committee on Way and Means in the US House of Representativies. This document provides a view into what was actually debated in the House in regards to carried interest taxation. He provides a detailed analysis for both sides of the issue and comes to the conclusion that it is necessary to tax the carried interest of private equity and hedge funds because it is a form of compensation. However, he does caution the House to take into account all factors to ensure fair tax treatment. Essentially, Orszag warns the House not to make a general solution as it could unfairly affect real estate partnerships.

United States Congress Joint Committee on Taxation. 2007. Present law and analysis relating to tax treatment of partnership carried interests. Washington, D.C.: Joint Committee on Taxation.

This book is a government document that provides analysis to the issue of carried interest taxation for the Senate Committee on Finance. It was prepared by the Joint Committee on Taxation thus proving to be a reputable source. This book provides background to the issue as well as information about private equity funds, hedge funds, and venture capital funds. It also has a detailed description of current tax law and how different business entities are treated under such law. Another thing that makes this resource valuable is that it provides economic data, which is important for interpretation. Overall, this book is a relatively unbiased source of information.

Weisbach, David. 2007. The taxation of carried interests in private equity partnerships. Private Equity Council, (accessed 1/31/08).

In this research report, the author argues that the bill brought up in Congress stating that carried interest should be taxed is not consistent with tax law for two main reasons. The first reason is that the work involved with a private equity investment is similar to the work in any other investment. Hence, it is valid to tax private equity carried interest at the same capital gains tax as other investments. Secondly, even if the taxation of carried interest was deemed reasonable, it would be too complex to differentiate between which type of revenue gets taxed at what rate. David Weisbach is a professor at the University of Chicago Law School with much expertise in the area of tax law. It is necessary to take into consideration that the Private Equity Council, a research organization that advocates the cause of private equity funds globally, funded this report.

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