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 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 1.6 2.1 2.0 2.1 2.0 2.0 2.0 2.0 2.0 2.0 9.8 19.9

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

Investment funds—such as private equity, real estate, and hedge funds—are often organized as partnerships. Those partnerships typically have two types of partners: general partners and limited partners. General partners determine investment strategy; solicit capital contributions; acquire, manage, and sell assets; arrange loans; and provide administrative support for all of those activities. Limited partners contribute capital to the partnership but do not participate in the fund's management. General partners can invest their own capital in the partnership as well, but such investments usually represent a small share (between 1 percent and 5 percent) of the total capital invested.

General partners typically receive two types of compensation for managing a fund: a fee tied to some percentage of the fund's assets; and a profit share, or "carried interest," tied to some percentage of the profits generated by the fund. In a common compensation agreement, general partners receive a management fee equal to 2 percent of the invested assets plus a 20 percent share in profits as carried interest. The fee, less the fund's expenses, is subject to ordinary income tax rates and the self-employment tax. (All income that is subject to the individual income tax, other than most long-term capital gains and dividends, is taxed at ordinary income tax rates.) In contrast, the carried interest that general partners receive is taxed in the same way as the investment income received by 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. Aside from the capital contributions general partners make to the fund, they typically are not exposed to fund losses.

This option would treat the carried interest that general 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 $20 billion in revenues from 2017 through 2026, according to the staff of the Joint Committee on Taxation.

An argument in favor of this option is that carried interest could be considered performance-based compensation for management services rather than a return on the capital invested by the general partner. By taxing carried interest as ordinary income, this option would make the treatment of carried interest consistent with that of many other forms of performance-based compensation, such as bonuses and most stock options. In particular, this option would equalize the tax treatment of income that general partners receive for performing investment management services and the income earned by corporate executives who do similar work. (For example, many corporate executives direct investment, arrange financing, purchase other companies, or spin off components of their enterprises, yet profits from those investment activities are not counted as individual capital gains for those executives and are therefore not taxed at preferential rates.)

An argument against the option is that a general partner's investment decisions could be considered more analogous to those of an entrepreneur than to those of a corporate executive. This option, however, would treat the income of general partners who manage investment funds differently from income earned by entrepreneurs when they sell their businesses. (Profits from such sales generally are taxed as capital gains, even though some portion of those profits represents a return on labor services provided by the entrepreneur.) Another argument against such a policy change is that it would reduce a general partner's expected after-tax return on his or her investments. That reduced incentive, in turn, could possibly diminish innovation and make private equity markets—and consequently businesses—less efficient. It is not clear, however, to what extent the lower tax rate on capital gains promotes innovation and market efficiency or whether promoting risky investment offers greater benefits than costs.

Some partnerships would probably respond to such a policy change by restructuring their compensation agreements so that the general partner's share of profits—often 20 percent—continues to be taxed at the preferential tax rates. For example, to make an investment requiring $100 million, limited partners could contribute $80 million to the fund and advance $20 million to the general partner as an interest-free, nonrecourse loan with the requirement that the borrowed capital be invested in the fund. If the assets of the investment fund were eventually sold for a profit, the gains realized by the general partner on the $20 million loan would equal 20 percent of the fund's total gains. The general partner would then claim that income as a capital gain subject to lower tax rates, which is similar to the way carried interest is treated under current law. If the investment was sold for a loss and the general partner could not repay the loan in full, he or she would not be liable for the unpaid loan: Under the terms of a nonrecourse loan, a borrower is not liable for any amount beyond the pledged collateral, which in this case would be the underlying assets in the investment fund originally purchased with the loan. However, even if the compensation agreement between limited partners and the general partner was restructured in that manner, federal receipts would still rise, although by less than they would if restructuring was not feasible. That is because, under current law, the general partner is required to treat the forgone interest on the nonrecourse loan as income and pay tax on it at the higher ordinary rate. The revenue estimates shown above reflect the likelihood and consequences of such restructuring.