March 4, 2013

Why Carried Interest Is a Capital Gain

By STEVE JUDGE

Steve Judge is the president and chief executive of the Private Equity Growth Capital Council.

The current debates on tax reform and government spending levels have often focused on raising taxes on carried interest. While many, including a recent opinion piece in The New York Times by Lynn Forester de Rothschild, have homed in on carried interest to raise revenue, little discussion has focused on how carried interest actually functions and why it was treated as a long-term capital gain in the first place.

Furthermore, changing the tax treatment of carried interest would not generate the significant revenue needed to close our huge budget shortfall. Some of the latest proposals on carried interest would deprive private equity, venture capital and real estate partnerships of the same long-term capital gains treatment available to other kinds of businesses – and would only pay for merely 3.1 hours a year in federal government operations.

In order to understand why carried interest is a capital gain, we should first examine what private equity does. Private equity is an industry of investors with management expertise and vision who form partnerships with pension funds, university endowments and charitable foundations to buy companies. It is the epitome of patient capital, investing in promising companies poised for growth and those in need of a turnaround.

The average private equity investment spans three to seven years. Companies owned by private equity are located throughout the country, touching nearly every community. More than eight million people work at private equity-owned businesses based in the United States.

Private equity funds are a partnership between the firm, or general partner, and the investors, also known as limited partners. Partnerships are the oldest form of business.

In the case of private equity, the managers contribute their understanding of the companies to buy, operational expertise and, often, capital to the partnership. The limited partners – pensions, endowments and foundations – contribute just capital to the endeavor.

The partnership structure results in an alignment of interest between the private equity general partner and their investors to expand companies over the long term. Private equity firms are true owners in the companies they buy. Because they develop strategic business plans, sit on boards and work to strengthen the companies they own over many years, the income they receive is a capital gain.

The private equity firm is compensated with this alignment of interest in mind. Typically private equity investors are paid a 2 percent management fee, on which they pay ordinary income tax rates, and a 20 percent carried interest of the partnership’s profits that is only paid after limited partners receive a preferred return of 8 percent.

Carried interest, therefore, is the profits share on the sale of a capital asset and not “ordinary income” as some would have it treated. In other words, it is a capital gain within a partnership and is rightfully taxed at the long-term capital gains rate — provided that the asset, or company, is held for more than one year.

To continue reading, please click here.