Carried interest is the share of profits that a general partner of an investment fund receives from his or her ownership interest in the fund’s assets. Typically, private equity funds are structured as partnerships to align the interests of managers and investors.
Currently, investments made by partnerships, such as private equity funds, are treated as capital assets, and the general partner’s share of the net gains is taxed on a “pass-through” bases as a capital gain.
Carried interest is found across a broad range of industries and market segments. Real estate developers typically receive carried interest when they develop office buildings or other properties. Venture capital firms and small business investment companies receive carried interest when they invest in a new start-up.
Capital gains treatment for carried interest has been enshrined in tax law for over fifty years and is based on the uniquely American principle that we reward those who take entrepreneurial risk, whether that risk involves investing capital or it involves years of time, effort, and vision.
The PEGCC strongly believes the present-law tax treatment of carried interest is founded on sound and settled tax policies:
Carried interest plays a crucial role in private equity growth capital investing. Carried interest is provided to the general partner in recognition of the substantial and material work required to restructure and direct the investments of the fund. It also serves to align the general partner’s interests with those of the limited partners. If the fund does well, the general partner shares in the gains; if the fund does poorly, the general partner receives nothing. Carried interest is also subject to what is known as clawback. First, it cannot be paid to the GP unless the fund has paid investors a certain pre-negotiated level of profit. And if the GP receives a carried interest payment on one investment and then subsequently fails to meet this threshold on a subsequent investment, it must return to investors the carried interest previously received. This makes carried interest fundamentally different in character, and much riskier, than ordinary wages. No one ever has to return the salary they earn once it is paid, regardless of performance.
A PEGCC analysis found that raising the carried interest tax rate could cut private equity investment in our economy by anywhere from $7 billion to $27 billion.