Carried interest is a special, or disproportionate-to-ownership, allocation of profits to the managers of a private equity (PE) or hedge fund partnership. While fund managers typically own about 2 percent of a fund, carried interest may allocate about 20 percent of the fund’s profits (above a threshold) to the managers. Some commentators deride carried interest as a “loophole” that allows high-income fund managers to reduce their taxes by obtaining preferential tax rates. These objections often arise in election years; for example, the UK’s Labour Party platform raised concerns about carried interest.

In broad terms, the concern is that carried interest is inappropriately taxed as long-term capital gains, subject to a lower preferential rate, when it should be taxed as ordinary income, at the higher ordinary rate. However, partnership taxation is complex, and the extent to which commonly raised talking points align with the underlying tax rules is not always comprehensively evaluated. In a new paper, I provide three analyses that suggest common concerns about carried interest are misplaced.

First, I evaluate whether the treatment of carried interest is inconsistent with the general principles of the current tax system (i.e., is a loophole). I find that the current treatment of carried interest follows the basic principles of the tax code and ensures that similar taxpayers are treated similarly, a principle known as “horizontal equity.” Consider a simple example. Tom invests in a stock and holds the stock for more than a year, making it a long-term capital asset. Tom sells the stock for a $100,000 gain. The maximum long-term capital gains tax rate is currently 23.8 percent (including the Net Investment Income tax), so Tom owes tax of $23,800. Now assume that the same transaction occurs, but instead of Tom owning the stock directly, Tom, Dick, and Harry form an equal (one-third each) partnership to own the stock. Partnerships are “flow-through” entities, so that any income earned by the partnership flows through to the partners and is taxed as if they earned the income directly. Thus, upon sale of the stock, the partnership has a $100,000 long-term capital gain, which is allocated to the partners who, in aggregate, pay tax of $23,800. Finally, assume the same transaction occurs, but the stock is owned by an equal partnership formed by Pam, Jane, and Sally. This partnership includes a special allocation – a carried interest – to Pam. Though each partner owns one-third, Pam gets allocated 50 percent of the income while Jane and Sally each get 25 percent (the reason for the special allocation is not particularly relevant; perhaps the investment partnership was Pam’s idea). The partnership again has a $100,000 long-term capital gain that is allocated to the partners who, in aggregate, pay tax of $23,800. This example illustrates the horizontal equity of the current treatment of carried interest: All taxpayers undertake the same transaction and pay the same tax. To the extent that similar transactions are taxed differently – e.g., if Pam paid more tax – it would likely distort economic activity. Prior work by University of Chicago Professor David Weisbach makes similar points.

Relatedly, carried interest is very similar to common corporate transactions. One of these transactions involves a corporation granting restricted stock or options to employees, who can make an election under Section 83(b) to recognize ordinary (i.e., compensation) income, equal to the amount of the grant’s value, immediately upon the receipt of the grant. Often, the value of the grant is low or zero upon receipt. Future profits from the stock are then eligible for preferential long-term capital gains treatment. This is similar to carried interest, which entitles a PE fund manager to potential long-term capital gains treatment of future profits. Another similar corporate transaction involves the issuance of multiple classes of stock. For example, a corporation could issue stock with voting rights that differ from its economic rights. Classes of preferred stock could be created so that certain owners (e.g., managers) are entitled to a disproportionate-to-ownership share of future dividends, which are taxed at preferential rates. Thus, the taxation of carried interest in PE funds is not unique but follows basic tax principles that apply to many similar transactions.

Second, I demonstrate that the current taxation of carried interest increases revenue for the U.S. government. As such, it is difficult to argue that carried interest is a loophole that reduces taxes. Again, consider a simple example. Assume Pam, Dick, Jane, and CalPERS form an equal partnership (one-quarter each) with no special allocations. They sell a stock for a $100,000 long-term capital gain. In this case, only $75,000 of the gain is allocated to taxable investors, with $25,000 being allocated to CalPERS, which is tax-exempt. Thus, the partners pay tax of $17,850 in total. Now, assume that Pam gets a carried interest in the partnership, so that she is allocated 40 percent of the income, while each of the other partners gets 20 percent. In this case, $80,000 of income is allocated to taxable investors, who pay $19,040 of tax in total. Thus, the U.S. government gained $1,190 in tax revenue from the carried interest. Note that this situation is common because PE funds often include foreign and tax-exempt investors that do not pay U.S. tax, while PE managers who receive carried interest usually pay U.S. tax. Thus, the special allocation shifts income from non-taxable (from the U.S. perspective) to taxable investors. See my other work for a more complete discussion of the presence and taxation of tax-exempt and foreign investors in PE funds.

Thus far, I have evaluated carried interest in the context of the current tax system, suggesting that carried interest is horizontally equitable and may increase government revenue. Third and finally, I revise my framework to evaluate common proposals to tax carried interest as ordinary income. These proposals generate less revenue than expected for two reasons (see work by Alan Viard, a senior fellow emeritus at the American Enterprise Institute, for a related discussion). First, most commentators assume carried interest is taxed at preferential rates. This is not always true. Carried interest is a special allocation of the income from an underlying partnership and, because partnerships are flow-through entities, is taxed based on the nature of the partnership’s income. Income, and therefore carried interest, may arise from ordinary (e.g., business income, interest income, non-qualified dividends) or capital (e.g., short- or long-term gains) sources. Notably, hedge fund carried interest is often short-term capital gains and non-qualified dividend income already taxed at ordinary rates. Similarly, venture debt or private debt carried interest is often interest income also taxed at ordinary rates. Thus, a change to treat carried interest as ordinary income would not increase the tax revenue from carried interest already taxed at ordinary rates.

The second issue minimizing the revenue from treating carried interest as ordinary income is that these changes may generate an offsetting ordinary deduction. Supporters of proposals to tax carried interest as ordinary income focus on the 17 percent rate differential between the ordinary rate of 40.8 percent (including Medicare tax) and the preferential rate of 23.8 percent, and believe that the government will gain revenue equal to 17 percent of the carried interest under their proposals (recall that some carried interest is already taxed as ordinary income, so this overstates the potential revenue gain). However, the carried interest now becomes potentially deductible as an ordinary deduction at a rate of up to 37 percent. If I assume a 37 percent deduction for simplicity (acknowledging that 37 percent is likely an upper bound on deductibility), the government loses revenue of 20 percent of carried interest (17 percent – 37 percent), rather than gaining 17 percent, by changing the taxation of carried interest to the method proposed by commentators for eliminating the carried interest loophole.

In sum, I make three main arguments. First, the current taxation of carried interest is not unfair because it follows the basic principles of the tax code and matches the treatment of similar transactions for corporations. Second, the current treatment raises revenue relative to cases without carried interest. Third, deeming carried interest to be ordinary income would have unforeseen consequences and, at best, raise little revenue or potentially reduce government revenue.

Given these facts, I argue that politicians and commentators should reduce their focus on the taxation of carried interest. The current treatment of carried interest seems to be neither causing distortions nor costing the government revenue. The tax code has other more substantial problems. I suggest commentators shift their focus to these other areas.

This post comes to us from Professor Steven Utke at the University of Connecticut. It is based on his recent article, “There is No Carried Interest Loophole,” available here.