June 14, 2007
Taxing Carried Interest As Ordinary Income: A Policy Recommendation
Posted by Victor Fleischer

I've posted a revised version of my Two and Twenty paper on SSRN.  The new version should be available on SSRN shortly; in the meantime, any interested readers can email me for a copy. 

I've added a policy recommendation at the end of my menu of reform alternatives.  Congress should adopt a baseline rule treating carried interest distributions as ordinary income.  Allocations of income that are disproportionate to the amount of capital a partner has invested in the fund should be treated as ordinary, regardless of the character of the income at the partnership level. 

Treating carry as ordinary income would protect our progressive tax rate system, which is consistent with widely-held principles of distributive justice.  Moreover, by treating carry more consistently with other forms of compensation, the rule would discourage wasteful tax planning activities, like the varied ways in which fund managers convert management fees into special priority allocations of carry. 

The Cost of Capital Method.  As I explain in the paper, there would still be a planning opportunity that would allow fund managers to structure around the new rules and achieve a mix of ordinary income and capital gains.  Specifically, fund managers could restructure the carry as a nonrecourse loan from investors.  From a policy standpoint, however, this result is acceptable.  Under tax rules that are already in place, fund managers would recognize ordinary income on the portion of their compensation that represents a return on human capital and would receive capital gain (or loss) only on the portion of their compensation that reflects true entrepreneurial risk.  The net result is equivalent to my "Cost of Capital" method, but imposed by private ordering into existing tax rules rather than by legislative fiat.

At the end of the day, then, we would have a simple baseline rule.  Carry is treated as ordinary income.  If fund managers want to go to the trouble of restructuring the carry as a non-recourse loan, existing rules dealing with interest (or forgiven interest payments) on that loan bring us to an appropriate tax result. 

Comments welcome off-line at victor.fleischer (at) gmail.com.

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