The Taxation of Carried Interest

Private equity sector and the exceedingly publicized

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private equity sector and the exceedingly publicized tax scheming undertaken by the Blackstone Group, there are other reasons why carried interests need serious attention, which include economic efficiency, revenue implications and tax equity. With respect to economic efficiency, a tax system is considered more efficient if similar activities receive the same treatment instead of creating a situation whereby tax rates influence how individuals allot their resources. In other words, a level playing field is an essential prerequisite for an efficient tax system. In this regard, if carried interest is considered to be a form of compensation that GPs receive for offering their management services, then the existing
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tax system is more lenient on carried interest relative to other types of compensation received for similar services. XX argues that carried interest should receive the same treatment as other incomes received for services. XX agrees with this view by stating that, when similar activities receive different tax treatments, distortions are created. As a result, a manager of a financial services company receives different tax treatment in comparison to a GP in a hedge fund or a private equity firm. XX points out that this should be alarming to tax policymakers due to the subsequent distortions. Revenue implications have also resulted in the heighted Congressional curiosity on carried interests. Since private equity funds account for about assets worth $ 1 trillion, the revenue missed by the Internal Revenue Service (IRS) when carried interest is treated as capital gains amounts to many billion dollars annually. Although this amount may be relatively small with regard to the total federal revenue, it is substantial when considering the key initiatives that Congress may consider funding such as increasing the tax incentives for higher education and expanding the State Children’s Health Insurance Program. Taxing carried interest as a form of capital gains also results in tax equity issues. Consider a situation whereby a manager received $ 5 million as a carried interest, had no any other form of income and did not file for exemptions or deductions, the tax rate for this manager is 15%. In contrast, the tax rate for a person earning a salary of 45,000 would be 20%. Billionaire Warren Buffet has expressed concerns about a tax system that allows people having multi- million dollar earnings to pay lower taxes when compared to their secretaries (XX). XX agrees with Buffet’s views and argues this issue is of importance especially at a time characterized by an increasing income concentration. Categorization of Carried Interest: Compensation or Capital Gains?
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From an economic perspective, those opposed to the current treatment of the carried interest as a form of capital gains amounts to a more inefficient tax system when compared to the a scenario whereby carried interests is treated as a compensation for the management services.
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Christopher Reinemann
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