In Two and Twenty, I offer a menu of reform alternatives for taxing carry.  One possibility, as noted in Sorkin's column today, is to tax carry as ordinary income.  But there is another method - what I call the "cost-of-capital method" - which might make for better tax policy.

A 20% carry is equivalent to two different economic arrangements:  (1) an at the money call option to acquire 20% of the capital of the fund, or (2) a nonrecourse, zero interest rate demand loan of 20% of the capital of the fund, the proceeds of which are used to buy 20% of the capital of the fund.  The "right" tax policy depends on which analogy we prefer. 

Under current law, income from the carry is both deferred and converted into capital gain, which is taxed at a lower rate. 

(1) The option approach.  If we treat carry like a call option, then income should be deferred, but then treated as ordinary income when realized.  This is how we treat non-qualified stock options in the corporate context. 

(2) The cost of capital approach.  But if we treat the carry like a loan, the proceeds of which are invested in the fund, then we get a different result.  Under the "cost of capital" method, we would tax GPs on the forgiven interest on the loan from the LPs.  Any appreciation in the value of the fund, however, would generate capital gain.  The cost of capital method reduces deferral, but preserves (in my view) an appropriate amount of conversion, reflecting the entrepreneurial risk of investing the fund. 

So, for example, imagine a $100 million fund with a standard 20% carry.  Each year, the GP would recognize income on 6% (or whatever the short term applicable interest rate is) times 20% carry times $100 million (the total capital in the fund).  The GP would recognize, in this case, $1.2 million of income annually, taxed at the ordinary 35% rate.  Any further appreciation in the fund, however, would generate capital gain.

I have much more to say, of course, including other reform alternatives, and detailed discussion of the pros and cons, in the full version of the paper.  I hope to have a revised version up on SSRN later tonight.

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