Tax Carried Interest as Ordinary Income

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

(Billions of dollars) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2014-2018 2014-2023
Change in Revenues 1.2 1.5 1.8 2.2 2.2 2.0 1.8 1.7 1.5 1.4 8.9 17.4

Source: Staff of the Joint Committee on Taxation.

Note: This option would take effect in January 2014. To the extent that the option would affect Social Security payroll taxes, a portion of the revenues would be off-budget. In addition, the option would increase outlays for Social Security by a small amount. The estimates do not include those effects on outlays.

Investment funds—such as private equity, real estate, and hedge funds—are typically organized as partnerships with one or more general partners managing the fund. The general partners determine investment strategy; solicit capital contributions; acquire, manage, and sell assets; arrange loans; and provide administrative support for all of those activities. Such partnerships also typically include limited partners, who contribute capital to the partnership but do not participate in the fund’s management. General partners can invest their own financial capital in the partnership, but such investments usually represent a small share of the total funds invested.

General partners typically receive two types of compensation for managing a fund: a fee tied to some percentage of the fund’s assets under management; and a profit share, or “carried interest,” tied to some percentage of the profits generated by the fund. A common compensation agreement gives general partners a 2 percent fee and 20 percent in carried interest. The fee, less the fund’s expenses, is subject to ordinary income tax rates and the self-employment tax. In contrast, the carried interest that general partners receive is taxed in the same way as the investment income passed through to the limited partners. For example, if that investment income consists solely of capital gains, the carried interest is taxed only when those gains are realized and at the lower capital gains rate. The general partners’ share of dividends is also taxed at the lower rate.

This option would treat the carried interest that partners receive for performing investment management services as labor income, taxable at ordinary income tax rates and subject to the self-employment tax. Income those partners received as a return on their own capital contribution would not be affected. If implemented, the change would produce an estimated $17 billion in revenues from 2014 through 2023. Almost all of the additional labor income would be above the maximum amount subject to the Social Security portion of the self-employment tax; however, the small amount of such income below the cap would affect the wage base from which Social Security benefits are calculated and thus increase federal spending in future years. The estimates shown here do not include any effects on such outlays.

Arguments in favor of this option reflect the view that carried interest should be considered performance-based compensation for management services rather than a return on the financial capital invested by the general partner. In accordance with that viewpoint, the option would eliminate two notable differences in the way carried interest and comparable forms of income are currently taxed. First, taxing carried interest as ordinary income would make its treatment consistent with that applied to many other forms of performance-based compensation, such as bonuses and most stock options. Second, the option would equalize the tax treatment of income that partners receive for performing investment management services and the treatment of income earned by corporate executives who do similar work. (The managers of publicly traded mutual funds, for example, also invest in a variety of assets. And the executives of many corporations direct investment, arrange financing, purchase other companies, or spin off components of their enterprises.)

Arguments against the option reflect the view that general partners’ investment decisions are more analogous to those of an entrepreneur than those of a corporate executive. From that perspective, this option would treat the income of partners who manage investment funds differently from that earned by entrepreneurs when they sell their businesses. Profits from such sales generally are taxed as capital gains, even though some of those profits represent a direct return on specific labor services provided by the entrepreneur. Another argument against such a policy change is that to the extent that carried interest is a reward for taking successful risks, the policy change would reduce the incentive for general partners to undertake such risks. That reduced incentive, in turn, would probably deter innovation, new products, and more efficient markets and businesses. It is not clear, however, to what extent a lower rate on capital gains contributes to such outcomes, or even whether promoting risky investment offers more economic advantages than disadvantages.

Some firms would probably respond to such a change by restructuring their compensation arrangements so that as much compensation as possible could continue to be treated as capital gains. (The revenue estimates shown above reflect the likelihood of such restructuring.) That could be accomplished if the limited partners made an interest-free nonrecourse loan to the general partner, who would then invest the proceeds of that loan in the fund. (A borrower is not personally liable for a nonrecourse loan beyond the pledged collateral, which in this case would be the general partner’s claim on future profits.) At the time the partnership sold its assets, any difference between the proceeds allocated to the general partner and the loan principal, plus the implicit interest costs attributable to that loan, would be treated as a capital gain or loss. An alternative (but complex) policy approach would be to treat all carried interest as if a nonrecourse loan had actually been made. Under that approach, the general partner would typically pay more in taxes than under current law but less than if all carried interest was treated as ordinary income.