The Taxation of Carried Interest

The Taxation of Carried Interest - The Taxation of Carried...

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The Taxation of Carried Interest: Understanding the Issues and Tax Treatment under Current Law Introduction Carried interest refers to the share of profits given to a general manager (GP) of an investment fund in addition to his/her ownership interest in the assets of the investment fund. Often, private equity funds use a structure similar to that of partnerships in order to ensure that the interests of investors and managers are in alignment[Wei08]. Presently, investments structured as partnerships such as private equity funds are often considered capital assets; as a result, the GP’s share of the net profit is usually taxed as a capital gain. Carried interest exists in diverse market segments and industries. For instance, real estate developers often receive carried interest when developing properties. In addition, small business investment firms and venture capitalists get carried interest when investing in a novel start-up business. The treatment of carried interest as a capital gain has been enshrined in the American tax law for over five decades and draws upon the distinctive American belief that people who take entrepreneurial risk should be rewarded, regardless of whether the risk entails capital investment or years of effort, time and vision (XX). XX emphasizes the important role that carried interest plays with respect to the growth of capital investments in private equity. Carried interest serves to recognize the substantial efforts of GPs in restructuring, directing and managing an investment fund. Moreover, carried interest helps in aligning the interests of the GP with the interests of the limited partners. The issue regarding carried interest stems from the fact that its taxation is based on the capital gains rate, which is lower when compared to the higher tax rate used in ordinary income. Those supporting the current treatment of carried interest as a capital gain maintain that the lower capital gains tax rate us reasonable since the nature of carried interest makes it is less
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reliable money source when compared to a regular salary. However, opponents argue that this exempts wealthier financiers from being taxed on money earned through offering service instead of investments on a capital asset. As a result, they advocate for the tax treatment of carried interest as an ordinary income instead of a capital gain. The purpose of this paper is to understand the current issues regarding the taxation of the carried interest and its current treatment under the tax law. The remainder of the paper is divided into five sections. The first section provides an overview of carried interest including how it works. The second section covers the issues on the taxation of current interest. The goal of this section is to analyze the arguments presented by those supporting the current capital gains treatment of carried treatment and those opposing the current treatment of carried interest. The third section focuses on the tax treatment of carried interest under current law. The fourth section reviews any legislative
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