Tax Treatment of “Carried Interest”

Abstract

The term “carried interest” is typically used to refer to profits interests issued by investment partnerships to their manager(s). It is an ownership interest in a partnership that has no liquidation value at grant, but entitles the holder to a share in future partnership profits, if any. The term “carried interest” hails from the fact that the “carried interest” holder typically does not invest any of the holder's own capital in the partnership. Thus, the “carried interest” holder is “carried” by those who do invest capital in the partnership. Currently, the income that a “carried interest” receives is generally taxed as capital gain. Many commentators believe that income allocated by a partnership to “carried interest” holders should be taxed as compensation because the income is for the services the partner performs for the partnership. This paper will examine what the proper tax treatment of “carried interests” should be based on what is the most economically equitable, fair, and efficient method of taxation. Based on the equity and efficiency concepts, the authors suggest that a portion of all “carried interest” income should be taxed as a payment in exchange for services (i.e., as compensation)—regardless of the nature of the underlying assets inside the partnership and regardless of the nature of the business the partnership conducts. However, what qualifies as a “carried interest” and the portion of the income that should be taxed as compensation are not as easily defined.