Private-Equity Taxation Explained, and Why It Should Be Left Alone
From a subscriber-only Wall Street Journal editorial on Monday:
The managing partners of equity funds generally receive compensation in two ways. They charge the fund investors a 1% or 2% management fee for finding high-return business opportunities and for orchestrating the portfolio. Those fees are taxed at the personal income tax up to 35%. But fund managers also typically lay claim to a 20% slice of the fund’s future profits. That return is called “carried interest” and is taxed at the long-term capital gain rate of 15%. Congress is considering reclassifying that income as labor compensation and taxing it at the 35% income tax rate.
That’s bad tax policy for a lot of reasons. “Carried interest” is long-term, risk-based investment income derived from future profits. Those profits are anything but a sure thing. Private equity managers get nothing from their equity holding until investors get all of their money back plus a negotiated return — which is a lot different than an upfront fee or a guaranteed wage or salary that comes as a paycheck every two weeks.
Far from being a clever tax dodge, carried interest plays a central role in the performance of private equity funds: It establishes an incentive structure which aligns the financial interests of the managers and investors. “Capital gain tax treatment of fund managers is not a ‘loophole’ that is being exploited by clever equity fund managers,” explains a recent legal advisory by the law firm Nixon Peabody, “but is a well-established principle of partnership taxation that has been enshrined in the Internal Revenue Code for decades.”
Overturning this tax doctrine would have negative effects on a wide spectrum of other investment funds which use “carried interest” incentive structures, including real estate and oil and gas partnerships, and venture capital firms. Doubling the tax rate on public equity will hurt them for sure, but the lower after-tax returns will undoubtedly mean fewer deals, which will do collateral damage to investors and entrepreneurs who depend on this capital for financial sustenance. Last year a record amount of private equity investment went into the coffers of family-owned businesses — not multibillion dollar firms.
The ultimate objective of tax revisionists is to have capital gains and other types of gains on investments taxed at the same rate as ordinary income. To the extent that the money to invest came from wages and salaries, this is double taxation. Instead of debating whether or not private-equity gains should be taxed as ordinary income, the better question to argue is why capital gains are taxed at all. Short of that, capital gains, including the “carried interest” described above, should be indexed to inflation before they are taxed, as the true gain on any investment is the real (after-inflation) one.
