March 11, 2007
Why We Should Change the Tax Treatment of Carry
Posted by Victor Fleischer

Today's New York Times has an article ("Of Private Equity, Politics and Income Taxes") about the Grassley proposal to tax carry as ordinary income.  Sorkin describes the growing resentment towards private equity, which seems to be driving the interest in changing the tax treatment of carry. 

Populist outrage isn't the reason we should change the tax treatment of carry.  To be sure, it's troubling from a distributive justice standpoint to see those with the highest incomes paying tax at a low rate.  (Note that this income is from returns from human capital, which we normally treat as ordinary income.)  But, as I discuss in Two and Twenty, the reasons for change go beyond the politics of resentment.  I discuss two of the reasons below.

1.  The Source of Capital. As the private equity industry has matured, it has put greater pressure on the partnership tax rules, which were designed with small business in mind.  The stakes are higher because funds are larger.  And many of today's funds are backed by tax-exempt LPs (such as pension funds and university endowments), which are indifferent as to the loss of an ordinary deduction for compensation. 

2.  Regulatory Gamesmanship.  Tax planning has become more aggressive.  Fund managers nominally receive a mix of management fees, taxed as ordinary income, and carried interest, taxed as capital gain. But several strategies are commonly employed to convert management fees into carry. 

First, as I discuss in the Missing Preferred Return, a significant portion of carry simply represents the time value of money.  Instead of indexing the carry to an interest rate or an industry average, partnership profits are measured from the first dollar of nominal profits, which ignores the cost of capital.  The tax rules give fund managers a strong incentive to do this, as carry is tax-advantaged compared to management fees.  Thus, instead of indexed returns, GPs must merely clear a hurdle rate (aka a disappearing preferred return) or no preferred return at all (in the case of most venture funds).

Second, fund managers convert management fees into carry on an annual basis.  As management fees come due, fund managers waive the fees in exchange for a priority allocation of additional profits.  So long as the receipt of these profits is subject to some market risk, the technique is not thought to trigger constructive receipt.  And so management fees, which would normally be taxed at 35%, are instead deferred a bit longer and then taxed at a 15% rate. 

Third, even the 1-5% GP capital contribution is no longer paid in with after-tax dollars.  Instead, GPs use the management fees in the first few years of the partnership to fund the GP capital contribution, creating a so-called "cashless capital contribution." 

In sum, distributive justice isn't the only reason to reconsider the current rules.  The current rules encourage wasteful tax planning, which distort the contract design and increase agency costs between the LPs and GPs. 

In the next post, I'll talk about reform alternatives.

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