Taxing Carried Interest

by EILEEN APPELBAUM

Private equity firms recruit investors—pension funds, endowments, sovereign wealth funds, hedge funds, wealthy individuals—for an investment fund. The private equity fund is structured as a partnership in which the sponsoring private equity company is the general partner and the investors in the fund are limited partners. The investment fund acquires a portfolio of operating companies with the expectation that the fund will make a profitable exit from the investments in a few years. The general partner (the private equity firm) makes the decisions about which companies to buy, how they should be managed, and when they should be sold. The limited partners share in any gains (or losses), but do not have a say in decision-making. The private equity firm typically sponsors multiple special purpose private equity investment funds, each of which is structured as a separate partnership.

Firms that sponsor private equity funds operate on a “two and 20″ model. They typically collect a flat 2 percent management fee on all money committed to the investment fund by the limited partners. The management fees cover the costs of managing the fund and its investments, including payments to members of the private equity firm for work they perform.

The private equity firm that sponsors the fund—the general partner in the fund—also receives 20 percent of all investment profits once a hurdle rate of return has been achieved. The remaining profits are distributed to the limited partners in proportion to the capital that they invested in the fund and put at risk. The profits that are received by the private equity firm are referred to as carried interest. They are distributed to the partners in the private equity firm and taxed at the lower capital gainsrate, currently 15 percent, not at the top personal income rate of 35 percent. (It is worth noting, as Paul Krugman does, that long-term capital gains were taxed at close to 30 percent from 1986 through 1997 when they were reduced to 20 percent; the current very low rates only started in 2003).

Private equity firms argue that the 20 percent of a private equity fund’s profits that they earn are a return on the equity they have invested—the capital they have put at risk—and should, therefore, be treated as capital gains and taxed at the lower rate.

Typically, however, a private equity firm contributes $1 to $2 to the private equity fund for every $100 the limited partners have invested in the fund. Thus, 1 to 2 percent of the fund’s profits are a return on the private equity firm’s investment in the fund; the remaining 18 percent is a form of profit sharing by the private equity firms’ partners. As with other forms of performance-based pay, these earnings should be taxed as ordinary income and not at the 15 percent capital gains rate.

Eileen Appelbaum is a senior economist at the Center for Economic and Policy Research and the co-author of ‘Leaves That Pay: Employer and Worker Experiences With Paid Family Leave in California.’

This article originally appeared in Economic Intelligence (U.S. News & World Report)

Like What You’ve Read? Support CounterPunch
Weekend Edition
August 28-30, 2015
Randy Blazak
Donald Trump is the New Face of White Supremacy
Jeffrey St. Clair
Long Time Coming, Long Time Gone
Mike Whitney
Looting Made Easy: the $2 Trillion Buyback Binge
Alan Nasser
The Myth of the Middle Class: Have Most Americans Always Been Poor?
Rob Urie
Wall Street and the Cycle of Crises
Andrew Levine
Viva Trump?
Ismael Hossein-Zadeh
Behind the Congressional Disagreements Over the Iran Nuclear Deal
Lawrence Ware – Marcus T. McCullough
I Won’t Say Amen: Three Black Christian Clichés That Must Go
Evan Jones
Zionism in Britain: a Neglected Chronicle
John Wight
Learning About the Migration Crisis From Ancient Rome
Andre Vltchek
Lebanon – What if it Fell?
Charles Pierson
How the US and the WTO Crushed India’s Subsidies for Solar Energy
Robert Fantina
Hillary Clinton, Palestine and the Long View
Ben Burgis
Gore Vidal Was Right: What Best of Enemies Leaves Out
Suzanne Gordon
How Vets May Suffer From McCain’s Latest Captivity
Robert Sandels - Nelson P. Valdés
The Cuban Adjustment Act: the Other Immigration Mess
Uri Avnery
The Molten Three: Israel’s Aborted Strike on Iran
John Stanton
Israel’s JINSA Earns Return on Investment: 190 Americans Admirals and Generals Oppose Iran Deal
Bill Yousman
The Fire This Time: Ta-Nehisi Coates’s “Between the World and Me”
Scott Parkin
Katrina Plus Ten: Climate Justice in Action
Michael Welton
The Conversable World: Finding a Compass in Post-9/11 Times
Brian Cloughley
Don’t be Black in America
Kent Paterson
In Search of the Great New Mexico Chile Pepper in a Post-NAFTA Era
Binoy Kampmark
Live Death on Air: The Killings at WDBJ
Gui Rochat
The Guise of American Democracy
Emma Scully
Vultures Over Puerto Rico: the Financial Implications of Dependency
Chuck Churchill
Is “White Skin Privilege” the Key to Understanding Racism?
Kathleen Wallace
The Id(iots) Emerge
Andrew Stewart
Zionist Hip-Hop: a Critical Look at Matisyahu
Gregg Shotwell
The Fate of the UAW: Study, Aim, Fire
Halyna Mokrushyna
Decentralization Reform in Ukraine
Norman Pollack
World Capitalism, a Basket Case: A Layman’s View
Sarah Lazare
Listening to Iraq
John Laforge
NSP/Xcel Energy Falsified Welding Test Documents on Rad Waste Casks
Wendell G Bradley
Drilling for Wattenberg Oil is Not Profitable
Joy First
Wisconsin Walk for Peace and Justice: Nine Arrested at Volk Field
Mel Gurtov
China’s Insecurity
Mateo Pimentel
An Operator’s Guide to Trump’s Racism
Yves Engler
Harper Conservatives and Abuse of Power
Michael Dickinson
Police Guns of Brixton: Another Unarmed Black Shot by London Cops
Ron Jacobs
Daydream Sunset: a Playlist
Charles R. Larson
The Beginning of the Poppy Wars: Amitav Ghosh’s “Flood of Fire”
David Yearsley
A Rising Star Over a Dark Forest
August 27, 2015
Sam Husseini
Foreign Policy, Sanders-Style: Backing Saudi Intervention
Brad Evans – Henry A. Giroux
Self-Plagiarism and the Politics of Character Assassination: the Case of Zygmunt Bauman