The rationale for the lower tax on the carry is that the general partner takes on risk similar to that of an entrepreneur when buying and selling portfolio companies. It’s not guaranteed that these companies will sell for a profit, so the lower tax is viewed as a reward for taking on the risk.
Critics of carried interest taxation seek reclassification of the capital treatment to ordinary income. Opponents suggest that if carried interest were taxed at the higher rate, it could positively impact the reduction of the U.S. budget deficit. Critics also argue that it is unfair that wage earners are forced to pay a higher tax on their salaries than general partners do on their management compensation.
The hedge and private equity fund industries have lobbied hard against changes to carried interest, arguing that carried interest aligns the interests of the general and limited partners. Proponents are concerned that if the tax incentive for the general partners is diminished, performance would suffer. Others argue that if the profits from carry decreased, then private equity firms might look for income in other ways, perhaps through an increase in the 2% management fee.
Proposed Legislation
A bill has been introduced in Congress related to taxation of carried interest: The Carried Interest Fairness Act of 2015 (H.R. 2889). Though it has not gained any traction, the bill seeks to amend the Internal Revenue Code to treat net capital gains related to partnership interests in investment service funds as ordinary income. Under the bill, transferred partnership interests in connection with the performance of services would be included currently in gross income.
What Investors Need To Know
Because private equity funds are alternative investment vehicles, they don’t receive as much regulation as publicly traded equities and mutual funds. Additionally, because much of the data behind private equity financials is kept private, there is not much transparency available to investors to verify the calculations and fees associated with their investments.
That means limited partners place a great deal of trust in the fund managers and their auditors. As a result, investors should be sure to perform their own due diligence. For instance, limited partners should thoroughly review partnership agreements and any other relevant paperwork. Investors should also verify that fund auditors are reputable and have experience auditing private equity funds. Investors should also keep in mind that private equity investments are generally higher risk, illiquid investments and, as such, they cannot be easily exited.
What investors should not do is use carried interest as the sole criteria for ruling out alternative investments, some of which are directed by some of the best minds in the financial industry. Many institutions and pensions have continued to put large sums in alternative vehicles and have performed well despite the fees. This in itself speaks to the success of these types of investments.
Adam Dauber, CPA, is a manager in the private client services group of CBIZ MHM LLC, a New York City-based accounting and business consulting company.