Carried Interest – Long-term Capital Gains or Ordinary Income

The carried interest debate has taken a back seat given the current turmoil on Wall Street. The carried interest question was lead by Senator Chuck Grassley (R-IA), ranking member on the Committee on Finance. During private equity’s heyday and subsequent Blackstone IPO, politicians began to examine the method of taxation on a piece of PE professional’s compensation – carried interest. Carried interest is designed to align the interests of the general partner and the limited partners in the fund. A private equity fund (LBO or venture) typically has a “2 & 20” structure, 2% annual management fee on committed capital and a 20% incentive fee where after the return of initial capital the general partners and limited partners split every dollar of profit 80 / 20. With Harvard Management rumored to be selling $1.5B in private equity investments at 50¢ on the dollar, it’s unlikely for the carried interest debate to gain much momentum. That said, Barack Obama is in favor of changing the taxation of carried interest, which could be lumped into a broader change in US tax policy.

Capital Gains Supports
Supporters of LTCG treatment stand behind the original intent of LTCG treatment of partnership interest – promoting investment and growth in American business. Eric Solomon’s testimony to Senator Grassley provided support of taxing carry as capital gains. Two reasons are highlighted in defense of the status quo, (i) venture capital and growth private equity promote small business and (ii) changing to OI would make US private equity less competitive in World markets. There is fairly sound logic behind the first argument; treating carried interest as capital gains promotes entrepreneurship through the pooling capital, skills, and ideas as well as risk taking. Gordon Gecko promoted the negative stereotype of private equity investors as corporate raiders, but many private equity firms partner with management to grow business creating and maintain jobs in America.

It is difficult to argue with a venture capital investor that venture and angel investments are providing necessary capital for smart growth. The VC industry was at the heights of its popularity during the tech boom of the late 1990s. The asset bubble the burst in 2002 and subsequent recession provided substantially more good than bad for American business. While many dot coms measured operating results in cash burn, the dot coms created a new industry where the US remains globally competitive and created new technologies that make other industries more competitive. Furthermore, venture investing provides necessary capital for growth in biotech and medtech firms that substantially improve US healthcare; a more recent phenomenon, clean-tech, may help reduce US
dependence on foreign oil.

LBO firms create returns for their LPs, commonly terms are internal rate of return (“IRR”) and cash-on-cash return, using three mechanisms, (i) financial engineering or leverage (a debt-to-equity mix consistent with a home mortgage 10-20% down), (ii) multiple arbitrage or expansion (buying a business at a purchase price multiple of 5x earnings and selling it for 10x earnings) and (iii) earnings growth by way of either revenue growth or operational improvement of the business. A recent BCG study of the viability of the private equity industry highlighted decade long eras in the industry; the 1980s were the leverage era, the 1990s were the multiple expansion era, the 2000s were the earnings growth era, and the 2010s will be the operational improvement era. Through operational improvements, LBO funds may improve the job security of many US workers as well as drive new operational expertise that will transfer to many other firms and industries.

The structural argument for carried interest to be taxed as capital gains surrounds partnerships accounting. The partnership or sole proprietor model was established to avoid double taxation. If the carried interest were taxed at the time of receipt as a profits interest, the partner would be taxed as ordinary income on the present value of the income stream and would again be taxed when the income is recognized by the partnership in the future. Additionally, the carried interest is analogous to an entrepreneur that puts “sweat equity” into a business; with a little seed capital, good ideas, and hard work, entrepreneur’s increase in equity value is taxed at the capital gains rate. It has been further highlighted that lawyers and artist sell skill (ordinary income) while private equity professionals are selling sweat equity in a firm, similar to an entrepreneur. Carried interest differs from options in that options do not have an economic right, cannot vote, and do not have a right to dividends, where as with carried interest, individuals are immediate owners, are taxed on their share of income, and are treated similar to owners.

Ordinary Income
The primary argument to tax carried interest as ordinary income is that carried interest in effectively performance-based compensation. With the huge sums of capital raised in the past decade or so, private equity no longer is flying under the radar; many believe the financial services industry is too highly paid, fleecing public pensions, endowments, and charities. The ordinary income crowd was lead by Peter Orszag, former director of the CBO and Obama’s Office of Management and Budget Director, and his presentation to the Senate Committee on Finance. The carried interest is compensation for services provided by the general partners and not a return on invested capital. At grant, general partners are only required to invest a nominal amount of capital to achieve capital gains taxation. The fund’s limited partners provide all of the capital and bear all of the risk on the downside for the fund. The general partners simply provide sweat equity, thus the limited partners have a right to capital gains and general partners are receiving a performance-based compensation. The main focus of the argument is on the lack of capital at risk.

Alternative Taxation Methods
There are three basic suggested alternative taxation methods for carried interest. The first method would be to tax the carried interest at grant, similar to a non-restricted stock option. The carried interest would be valued similar to an option using an option pricing model (Black-Scholes); the general partner would pay ordinary income tax on the value of the carried interest at grant and the limited partners could take a deduction for the amount. The taxation would accelerate tax receipts for the US government and general partners would pay net capital gains or losses upon revaluation. The method would be slightly cumbersome to value the carried interest, potentially costly to have a third party value, and would leave room for general partners to favorably set assumptions to lower the value. US tax code abides by the notion of convenience, without a corresponding income stream, it may prove difficult for some private equity professionals to pay the tax bill.

A second proposed system would be to pay taxes at distribution as ordinary income – carried interest is entirely performance-based compensation. The carried interest would be treated similar to a nonqualified corporate stock option. The tax deferral would continue as with the current system. Many economists feel carried interest is a mix between incentive compensation and capital gains, full taxation as ordinary income is likely imposes too stringent of a tax.

The third option, which appears to have some merit, is to treat the carried interest as a non-recourse loan from the limited partners to the general partners. In this system, the general partner would pay ordinary income on the implicit interest rate on the loan; the interest would have to be a market rate. In a $100mm fund, the general partner would in effect be receiving a $20mm loan from the limited partners; each year the general partner would have to pay tax on the implicit interest (5% of $20mm = $1mm of interest @ 35% à $350,000 tax bill). This option more closely reflects that a portion of the carried interest is performance compensation and a portion is capital appreciation. Opponents of this option would again point to the convenience factor; it may prove difficult to pay the $350,000 tax bill without an income stream. Limited partners receive a distribution from the fund each year to pay their portion of the annual tax bill to mitigate the convenience issue.

With the US staring down a long recessionary road, incenting providers of capital to continue to prudently deploy the capital for growth is necessary. While it may be difficult to explain to your grandmother why carried interest is not performance-based compensation, it may be best for the US economy to delay an action on carried interest. With all likelihood, policy makers will take action to shift a portion of carried interest to ordinary income. Given a change, the non-recourse loan appears to be the best option. To mitigate the convenience issues, the implicit interest taxation should continue to be delayed until realization. Keep the US entrepreneurial spirit alive.